On November 1, Brazil’s Itau Unibanco (ITUB) reported third-quarter adjusted net income, excluding one-time items, of 3.94 billion reais ($2.3 billion).
That was up from 3.16 billion reais in the third quarter of 2010, a 24.7% increase. The results also easily beat the analyst estimate of 3.65 billion reais for the quarter. (Reais is the plural of real.)
Great numbers. But before you rush out to buy these shares—and the stock is a member of my long-term Jubak Picks 50 portfolio—you need to get your head around this number: In the quarter, the bank posted an annualized return on equity of 22.7%. That was up from 22.2% in the second quarter.
As you’d expect, that measure of profitability at Itau obliterates the return on equity at troubled US banks. The comparable measure at Citigroup (C) is just 6.72% for the last 12 months, and negative-1.45% at Bank of America (BAC).
But it also humbles the profitability at some pretty good US banks. JPMorgan Chase (JPM), for example, shows a return on equity of 10.9%, PNC Financial (PNC) 11.92%, and US Bancorp (USB) 14.24%.
That ought to raise a big, screaming question in your mind—Is the Itau Unibanco story that good? Or is there some huge burden of risk hanging over the stock that means you shouldn’t buy it, even with that kind of differential in profitability?
I certainly wouldn’t say that Itau Unibanco doesn’t face some risks—but they are surprisingly modest. And even after accounting for them, I think this is a bank stock worth buying. Even in the current market for bank stocks.
The big risk for any bank these days is bad loans. That’s especially a worry because Brazil has been on a credit binge, with average annual credit growth of 22% since 2003. That has brought total credit in the private sector to 47.3% of Brazil’s GDP in 2010 (from just 26% in 2002).
Brazilian households now pay 20% to 25% of their incomes on debt payments. That compares to a ratio of just 14% in the United States...when the credit bubble burst.
But there are some solid reasons to think that Brazil isn’t headed toward a massive credit bust. First, private credit in Brazil is incredibly expensive, with an average annual interest rate of 47%. Borrowing hasn’t, by and large, gone into mortgages or other long-term borrowing, and it hasn’t created, by and large, a huge asset bubble.
Second, unlike in the United States—where just about nobody has gone to jail because of the way that banks behaved during the creation of the mortgage bubble—under Brazilian law, controlling shareholders in a bank have unlimited personal liability. (Think that might focus your mind?)
Third, Brazil’s banks are amazingly over-reserved against bad loans. Existing reserves at Itau Unibanco, for example, equal 156% of the bank’s non-performing loan balance in the third quarter.
And fourth, the Banco Central do Brasil has begun to lower interest rates to stimulate growth. That has the effect of increasing net interest margins—the difference between what a bank pays to raise money and what it charges borrowers—and provides some relief to indebted consumers (by lowering interest rates and encouraging growth.)
Non-performing loans—loans past due by 90 days or more—did rise at Itau Unibanco, to 4.7% at the end of the third quarter, an increase of 0.2 percentage points from the second quarter. And that 4.7% number wasn’t particularly clean. Once you took account of renegotiated credits and charge-offs, the increase was more like 0.5 percentage points.
But bank CEO Roberto Setubal has been talking recently as if he thinks this is close to the worst that the bad-loan situation will get, thanks to the central bank’s interest-rate cuts and the likelihood that the economy will accelerate next year. The bank told investors to expect a small increase of about 0.2 percentage points in non-performing loans when it reports fourth-quarter results.
At a November 7 closing price of $18.55, the ADRs (American Depositary Receipts) of Itau Unibanco trade at a price-to-earnings ratio of 9.8 times projected 2011 earnings per share. The analyst consensus is calling for earnings growth of 11% for all of 2011, which could well be low if the fourth quarter turns out to be as profitable as the third.
I think $24 is a reasonable one-year target price for the ADRs.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Itau Unibanco as of the end of September. For a full list of the stocks in the fund as of the end of September see the fund’s portfolio here.
