SAN - Santander Brazil: Resilient Operating Trends Lead To Undervaluation

Summary

• Santander Brazil has strong fundamentals, but macroeconomic headwinds are impacting its financial performance.
• Underlying trends continue to be strong, especially regarding customer growth and engagement, boding well for a recovery during 2023.
• Its current valuation is quite cheap and also offers a very interesting dividend yield.

Banco Santander Brazil ( BSBR ) has strong fundamentals and has reported relatively good results despite the current tough economic background, while its shares have been weak and the bank now has a low valuation.

Background

As I’ve analyzed in previous articles , I like Santander Brazil as a long-term play within the Brazilian banking industry due to its quality profile, but in my last article I changed my stance to ‘neutral’ as the macroeconomic environment is challenging and this could lead to higher loan losses in the near future, reducing the bank’s ability to return excess capital to shareholders.

For investors who aren’t much aware of Santander Brazil’s profile, the bank is part of the Spanish financial group Banco Santander ( SAN ). This is the bank’s largest shareholder with a stake of about 90%, while the rest trades as free-float. Santander Brazil has been listed since 2009, as the group’s strategy is for local units to have some sort of financial autonomy, which means that they don’t rely solely on funding from central operations.

Santander Brazil’s operations are mainly focused on retail and commercial banking, being one of the largest private banks in Brazil. The bank’s loan credit portfolio amounted to some $95 billion at the end of last September, which was well covered by its $91 billion in deposits, being well diversified across loan segments. It has more exposure to individuals rather than corporates, even though it has significant exposure to more cyclical loans, such as credit cards or payroll loans.

Since my last article on Santander Brazil, the bank has reported its most recent quarterly earnings, which were positive considering the weaker economic environment Brazil has experienced in the past few months.

Earnings Analysis

Santander Brazil has reported its Q3 2022 earnings at the end of October, which showed a growth slowdown compared to the previous quarters. During the first nine months of 2022, Santander Brazil’s net interest income declined by 5% YoY to $7.57 billion, due to lower market NII, while fees increased by 2% YoY to $2.73 billion. Total revenues amounted to $10.3 billion, a decline of 3.3% YoY.

While Santander Brazil has a very good growth history over the past few years, especially in the individuals segment, the bank has anticipated to some extent the current economic cycle and has reduced its risk appetite in the past few quarters, expecting some pressure on individuals due to higher interest rates and high levels of inflation, which are factors that reduce the disposable income of individuals.

Therefore, while Santander Brazil’s strategy was to push consumer loans over the past few years, this strategy changed in recent months with a focus on maintaining sound asset quality. Nevertheless, the bank expects the Selic rate to come down and some consumption recovery during 2023, and then it will again push its business toward sustainable growth.

Despite slower growth, the bank sees its business improving given that Santander Brazil has been able to increase business diversification, achieve higher customer loyalty, and increased cross-selling. Moreover, in the corporate segment it expects to report the best year in its history, with business being supported from SMEs to large corporates.

Regarding costs, the bank’s goal is to remain one of the most efficient banks in Brazil, aiming to reduce its operational costs and maintain good levels of efficiency. Despite that, during the first nine months of the year, its total expenses amounted to $3.2 billion, an increase of 6.8% YoY. Due to the combination of lower revenues and higher costs, the bank’s efficiency deteriorated, but still remains at very good levels. Indeed, its cost-to-income ratio, a key measure of efficiency in the banking sector, was 35.7%, which is still among the best in the banking industry across the globe.

Due to slower economic activity and anticipated credit deterioration, Santander Brazil’s allowance for loan losses increased by 63% YoY during the first nine months of 2022, to $3.19 billion. Despite this increase in provisions, the bank’s non-performing loan (NPL) ratio was quite stable at 4.2-4.3% during the past few quarters, showing that loan defaults are still at a moderate pace. However, investors should take into account that credit defaults usually have a time lag of about six to twelve months from the start of an economic downturn, thus a potential higher NPL ratio is a critical factor to follow in the near future.

Despite a challenging operating backdrop, with the bank being pressured from lower NII, higher costs and increasing loan loss provisions, its profitability remained at very good levels. Its net income was $2.16 billion in 9M 2022, a decrease of 10% YoY, but its ROE was 19% during this period, down by 2.5 percentage points compared to the same period of last year.

This decline is mainly justified by cyclical factors rather than fundamental issues, considering that Santander Brazil continues to increase its customer base at a healthy pace (to 57.7 million at the end of September, +11% YoY), the number of loyal customers, and also the penetration within its existing customers, as shown in the next graph.

Therefore, this enlarged customer base and product expansion should be strong supports for higher revenues in the coming quarters, particularly on commissions while on NII new credit volumes should remain somewhat muted through 2023.

Regarding asset quality, the bank’s efforts to move its new loans to customers with higher credit ratings in recent months have led to lower delinquencies in the most recent loan vintages, boding well for credit quality in the coming quarters. While it’s exp ected that higher provisions will continue to be a drag on the bank’s earnings and profitability for a few more quarters, especially if the Brazilian economy enters into recession, the bank is well prepared to resume growth when economic conditions improve.

While at this stage it's probably too soon to predict where is the bottom of the current down cycle, Santander Brazil seems confident that business conditions will improve during 2023, most likely in the second half of the year.

The street seems to agree with this view given that, according to analysts’ estimates , Santander Brazil is expected to report a slight improvement in revenue and earnings next year compared to 2022, and resume growth from 2024 onwards. Indeed, its revenue is expected to be about $18.5 billion by 2025 (vs. $14 billion in 2022), and its net income should reach $3.7 billion (vs. $2.8 billion this year). This growth should come mainly from organic sources, namely customer growth and higher engagement, even though small acquisitions are not completely ruled out if they fit the bank’s strategy.

Regarding its capitalization, Santander Brazil has a good capital situation, given that its core equity tier 1 [CET1] ratio was 11.3% at the end of September, an increase of 20 basis points compared to June. While this capital position is sound, the current weak economic cycle and uncertainty regarding potential credit losses in the coming quarters are two major headwinds for higher excess capital distributions, even though the bank has maintained its distribution policy, both through dividends and interest on capital, in recent months.

Indeed, the bank has cut its distributions in the recent past, which seems to be a sensible move due to macroeconomic headwinds and a lower capital buffer, but considering its distributions made during 2022 , Santander Brazil currently offers a dividend yield above 8% at its current share price, which is quite interesting for income investors.

Conclusion

While Banco Santander Brazil has very good fundamentals, the current economic down cycle is putting pressure on its financial performance, which should be temporary given that its business continues to report strong underlying trends, especially regarding customer growth and improved engagement.

However, the market has penalized its share price quite significantly in recent months, leading to a much lower valuation than compared to its historical average. Indeed, Santander Brazil is currently trading at 0.9x book value, while its historical average over the past five years is 1.4x book value, showing that is shares are undervalued and there is significant upside potential when operating momentum improves.

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