CIB - Nu Holdings: Valuation Has Run Far Ahead Of Fundamentals

2023-11-14 12:33:29 ET

Summary

• Latin American banking company Nu has seen its share price skyrocket this year.
• While the bank is performing well, I'm skeptical that its current growth tactics will end up being sustainable when an economic downturn hits.
• 7x book value and more than 40x forward earnings is an awfully steep price for an emerging market bank.

Nu Holdings ( NU ) is a Latin American bank based in Brazil. The company grew rapidly by offering products such as no-cost debit cards which were new innovations for that market at that time.

Nu has gained a large user base in Brazil, and the bank has become GAAP profitable, which is an accomplishment when compared to many FinTech firms. Nu has sought to build on its success in Brazil by expanding into the Mexican and Colombian markets. However, growth has been slower abroad, perhaps because its product innovations aren't quite as revolutionary now as they were in the mid-2010s and the incumbent banks have lowered fees to remain competitive. I have a much deeper analytical dive into Nu's business model here.

In any case, with the rebound in more growth-focused equities, NU stock has soared in recent months. Should investors stick with the bank through this earnings season? I'd argue no, in fact I'm moving from a hold to a sell rating as I believe the valuation has gotten far ahead of fundamentals. My concerns, in addition to the lofty valuation for a bank, are around funding costs and the amount of credit risk that Nu is taking.

Nu Is Offering High Deposit Rates

One thing that has jumped out to me is just how aggressive Nu is in terms of trying to attract deposits. For example, at the bank's Mexican website , we see that it's offering a 15% fixed interest rate on savings as of this writing.

This offer pencils out to 16.18% in nominal annualized terms and 11.57% in expected real returns after subtracting the estimated Mexican inflation rate going forward.

Mexico's Central Bank is currently at an 11.25% overnight rate, meaning that Nu is offering an absolutely massive premium - 3.75% - to the Central Bank. For comparison, the U.S. Fed Funds rate is at about 5.3% now. If an American bank paid a 3.75% premium to that - offering depositors 9% per year, we might see that as a sign of desperation rather than merely being a juicy deal.

Investors might overlook this since it's Mexico, an emerging market, and there may be a perception that financial markets behave differently there. But at the end of the day, banking is a pretty simply business. Borrow at a relatively low rate, lend at a higher rate, capture the difference as your profit. If Nu is going to pay interest rates well above what the traditional banks are offering, it needs to do something else differently to make acceptable returns on equity.

So far, one thing Nu has done differently is that it extends credit to a lot of customers that the traditional banks tend to shun. I can't speak for Brazil, but in Colombia where I live, the leading three banking organizations tend to lend primarily to the upper classes of society and prefer folks who have high-paying jobs or work for the government. For the majority of Colombians, it's difficult and costly to obtain a mortgage or get access to personal credit.

Nu has arrived in the Colombian market and has more liberal policies toward taking on new clients and extending credit to folks with less robust credit histories. So far, this has worked well for Nu, and the business model was tested and performed acceptably during the early days of the COVID-19 pandemic.

However, I remain skeptical that Nu's more aggressive lending standards will fare well in a broader and more sustained economic downturn. Paying far above average rates on CDs and then using that money to make more aggressive personal loans than rivals is a great formula for supercharging growth during an economic expansion, but it exposes Nu to a lot of risk that the more conservative LatAm banks aren't facing.

So much of the English-language commentary I see about Nu and other upstart banks focuses on technology. I think that's a mistake. The traditional banks now have fine IT departments. Bancolombia ( CIB ) built Nequi, Colombia's largest mobile wallet/payments platform. CIB stock sells for less than 5 times earnings at the moment. Similarly, Peru's Credicorp ( BAP ) operates Yape, a digital wallet with more than 10 million users (more than a third of the country's adult population) Credicorp stock also sells at a sharply discounted valuation today.

My point here being that several leading LatAm banks have capable digital transformation efforts and are selling at rock bottom valuations. As such, I find the case for Nu being worth 43x times forward earnings today and 7x book value based purely on technology to be a flimsy one.

In my view, if you're bullish on Nu, you have to think the bank's more aggressive lending strategy is going to pay off and that Latin America has graduated to being a stable region where it makes sense to lend to less than pristine credit customers. The big entrenched LatAm banks still aren't eager to lend to the masses; they're happy to stick to the profitable but fairly small upper class lending niche where they are confident that they will be repaid on their loans.

If Nu can galvanize a broad adoption of financial products among the middle and lower classes of Latin America, it could become a massive enterprise and eventually grow into its $40 billion valuation. That said, I'm concerned that bulls seem overly focused on the technology bit, whereas from my perspective, the real differentiation in business model is with Nu's customer base and aggressiveness of lending compared to traditional banks. And, if and when a steep recession hits Latin America, those credit risks could come home to roost.

Q3 Earnings Thoughts

There are a few key metrics that I will be watching in Nu's Q3 earnings report.

As fellow author Penny Stocks Today wrote recently, Nu has seen its credit delinquencies move up pretty significantly over the past year. In fact, on both a 15-90 day non-performing loan (NPL) and 90+ day basis, the firm's credit metrics are nearing their worst levels on record dating back to 2017. This should raise some concern, given that the economies where Nu operates have been (relatively) strong performers since 2020. If Nu continues to see credit metrics tick the wrong way now during an economic expansion, it bodes ill for what happens during the next recession.

I'm also interested to see what the bank's cost of deposits and net interest margin look like. I'm highly skeptical that paying CD rates above the market is a winning long-term strategy, though it can certainly provide short-term growth.

That said, Nu has grown much more slowly in Mexico and Colombia since its launch in those markets as compared to its growth in its original Brazilian market. Perhaps the high interest rates are simply a cost of marketing. In any case, it will be interesting to see how the bank's user and deposit numbers look this quarter.

On the lending side, we've seen a slowdown across much of Latin America over the past couple of quarters. In Bancolombia's just-reported quarter , for example, it shrunk its loan book slightly as it is battening down the hatches amid a rapidly decelerating Colombian economy. Will Nu play defense as well, or will it continue with its contrarian growth strategy?

NU Stock Verdict

Nu has meaningfully improved its financial results since I last covered the company at the beginning of 2023. Credit is due, as management has executed well despite less-than-ideal macroeconomic conditions. So I'm not taking anything away from the bank on its operational results to-date.

That said, the stock is up more than 80% over the past 12 months which completely changes the valuation framework. At $5 per share, we could debate whether or not Nu would ever become strongly profitable and validate its business model in other LatAm markets outside of Brazil.

Up here at $8.60 per share, the valuation is stunning. The market is now assigning a $40 billion market capitalization to Nu. The market caps of the leading banks in Chile, Peru, and Colombia are $10 billion, $9 billion, and $7 billion, respectively, to give a sense of scale. Valuing a LatAm bank at $40 billion requires a strong leap of faith. Perhaps I'm jaded from having lived and invested in the region too long, but $40 billion is simply a massive number for a firm that is as small as Nu is today. And the 7x book value ratio is simply eye watering.

While earnings are growing nicely now, I'm worried that Nu is using low-quality growth from expensive deposits to juice its metrics now. In the long run, though, I'm skeptical that paying 15% on deposit accounts to draw in hot money is a sustainable formula in banking.

Maybe Nu can bring banking to the masses in South America and eventually grow into its lofty valuation. However, from my view, the valuation has run far ahead of any reasonable 3-5 year growth outlook. I'm doubtful that paying 7x book value and more than 40x forward earnings for NU stock today will work out well over a long time horizon.

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