2023-09-22 15:13:30 ET
Summary
- Banco de Chile is probably the best Chilean bank, given its balance sheet quality, excellent efficiency ratio, and outstanding Basel III ratios.
- Potential regulatory headwinds and disinflation followed by interest rate cuts may affect BCH's profitability and ability to distribute dividends.
- At the current market price, BCH offers an 8% margin of safety, however. Using price to book BCH is overpriced, especially compared to its regional peers BDORY and CIB.
- I give BCH a hold rating due to the declining interest rates environment, though I will keep following the Chilean banking system, considering the country`s potential.
Thesis
Latin American banks offer great opportunities for entrepreneurial investors—Better-looking balance sheets with higher Basel III ratios than its European and American counterparts combined with juicy dividends. I am on a quest to give you a deeper understanding of the banking landscape in the region, and today, I will present you Banco de Chile ( BCH ). It is the leading Chilean bank with the highest net income, best efficiency ratio, and most profitable bank measured with return on average capital and reserves (ROACR). BCH pays generous dividends and using a dividend discount valuation model it offers an 8% discount on the current market price.
Despite all the substantial numbers, I give BCH a hold rating due to potential regulatory headwinds that might temporarily affect banks' profitability and ability to distribute dividends. On top of that, I would like to see the results from disinflation followed by interest rate cuts by the Chilean central bank.
Given the higher rate of disinflation and 100 basis point rate cuts in July, I believe there is further room for more reduction. Therefore, a lower-than-expected rate path may be in the works, even though the banks assume in a base case scenario that the Chilean central bank might slow down at its three remaining policy meetings.
Company Overview
Banco De Chile is the leading bank in the country, as shown on the graph below from the last company management financial review for Q2 .
Banco de Chile management financial review Q2
In the long term, the efficiency (cost to income) ratio is the most critical metric for banks` performance. Here BCH excels with it at 36.4%. It is well under its competitors, Banco Santander-Chile ( BSAC ), Scotia Bank Chile, and Banco de Credito e Inversiones. The lower cost to income ratio, the better the company`s bottom line and return on capital. BCH realized the highest ROCR, beating its peers by more than 30%. The credit risk is well managed, as seen in the image above. BCH`s 90-day loans past due are 1.28%, second to Banco de Credito and below the Chilean Average of 2.0%.
A second quarter of net interest margin ((NIM)) compression suggested that disinflation and higher rates are starting to weigh into Chilean banks' Q2 profits, but cracks are now visible. The image below the last presentation compares BCH and its Chilean peers' income and balance sheet metrics.
Banco de Chile presentation
Along with Banco Santander, BCH owns the largest portfolio of loans and AUM. However, BCH`s profitability fared much better due to its more robust asset quality (lower provisions) and more durable net interest income basis. Key peer BSAC management had earlier locked in a low inflation view and, as a result, is still paying the price through lower NIMs over the upcoming months.
Interestingly, the Preferred Bank to Change metric BCH leads the pack, with 25 % of respondents choosing its services. The customer attrition rate is another metric affirming BCH quality. A stable customer base is foundational for any business; banks are not exceptions to that rule. The lower the attrition rate, the lower the banks` liquidity risk.
Company Financials
Chilean banks like to use all available funding sources: interbank borrowing, debt issuance, and client deposits. Like the BSAC balance sheet structure, BCH relies on all three to finance its operations. The table below shows the balance sheet composition and a few solvency and liquidity metrics. The data is from the last financial report .
Asset ratios: assets structure | |
Cash/Total Assets | 4.6 % |
Loans (total)/Total Assets | 71.3 % |
Consumer loans/Total Assets | 8.7 % |
Mortgage Loans /Total Assets | 21.1 % |
Commercial Loans/ Total Assets | 36.4 % |
Bonds/Total Assets | 14 % |
Liability ratios: capital structure | |
Deposits/ Total Liabilities | 56 % |
Interbank borrowings/ Total Liabilities | 11 % |
Company bonds/ Total Liabilities | 18 % |
Other financial instruments/Total Liabilities | 0.5 % |
Equity/ Total Liabilities + Equity | 9.1 % |
Solvency ratios: | |
Loans /Deposits | 139 % |
Cash/Deposits | 9.1 % |
Borrowings (inc. bonds)/ Total Assets | 27 % |
Loans to deposit ratio is 139%, but as I mentioned, BCH uses interbank borrowings and bond issuance. The former represents 11% of banks’ liabilities, while the latter is 18%. In my opinion, such a composition has its advantages. Usually, bond issuance is costlier compared to deposits, but fixed debt instruments mitigate liquidity risk due to strict redemption terms. Interbank financing costs are between and sometimes even below the client`s deposit interest rates.
Let's go deeper into loans and deposit structure.
Banco de Chile presentation
The loans are well diversified between commercial, consumer, and mortgage loans. Thus distributing banks' credit risk among various lenders. On the right side of the balance sheet are the demand deposits, which constitute 26% of bank liabilities, and time deposits 30%.
The loan delinquency and coverage ratios are generally good; however, in the last quarters, they have climbed up. That said, both metrics are still better than the Chilean average .
Banco de Chile presentation
BCH has the highest coverage ratio with additional allowances compared to its competitors. Talking about risk is futile without mentioning Basel III ratios. The table below shows BCH's capital adequacy metrics. The data is from the last financial report.
Capital (in millions of Chilean peso): | |
Regulatory Capital | 6,228,885 |
Tier 1 capital | 4,857,967 |
Common equity tier 1 (CET1) | 4,675,184 |
Risk-Weighted Assets | 36,556,606 |
Basel III Ratios: | |
Regulatory capital ratio (Capital adequacy ratio) | 17.8% |
Tier 1 ratio | 13.2% |
CET1 ratio | 12.7% |
LCR | 317 % |
NSFR | 136 % |
Banco de Chile's risk metrics are above the country`s average. Liquidity coverage ratio ((LCR)) and CET1 ratio are highest among Chilean banks.
The last quarter of net interest margin ((NIM)) compression suggested that disinflation and higher rates are starting to weigh into Chilean banks' Q2 profits. BCH's profitability fared much better than BSAC due to its stronger asset quality (lower provisions) and more durable net interest income basis. The image below shows BCH performance metrics.
Banco de Chile presentation
Higher fee and commission income from its higher-margin credit lines, such as credit cards, have partially offset some macro headwinds. Still, overall, there has been a considerable 1.57% NIM decline year over year. The weaker last quarter did not adversely affect banks` return on capital, as seen in the table below.
ROE | 25.6 % |
RoTE | 26.1 % |
RoCET 1 | 27.4 % |
ROA | 2.2 % |
The Chilean Central Bank set a new countercyclical buffer requirement to increase the minimum CET1 ratio for all Chilean banks by 50bps. Though a more significant capital buffer limits the bank's income-generating base, BCH's future earning ability will be affected. Therefore, even while management hasn't indicated any dividend reductions, its ability to increase dividends might be impacted. BCH distributes dividends with the highest yields compared to BSAC and ITCL.
Seeking Alpha
Company Valuation
To calculate BCH value with the Dividend Discount Model, I have to measure the price of the company's equity and levered beta.
To obtain those numbers, I use the following steps and assumptions:
- Risk-free rate equals the 5Y average of USA long-term Government bond Rate, 2.2%.
- Growth rate, g, equals the 5Y average of the USA long-term Government bond Rate, 2.2%.
- Chile's equity risk premium is 6.28 %.
- BCH's dividend pre-share $ 2.15
- BCH unlevered Beta 0.42
- BCH Debt/Equity ratio %.
- BCH effective tax rate 27 %.
-
- Calculate Levered Beta with the formula below:
Levered Beta = Unlevered Beta * (1+D*(1-T)/E).
2. Calculate the discount rate (discount rate as the cost of equity) using the resulting value for the leveraged beta. The formula I use is:
Cost of Equity = Risk-Free Rate + (Levered Beta * Equity Risk Premium).
3. Calculate the Terminal Value of dividends considering the Cost of Equity and Expected dividend growth:
Terminal Value = Dividend per share * (1 + expected dividend growth) / (Cost of Equity – Expected Dividend Growth)
4. Calculate the Present Value of Terminal Value assuming a constant discount rate for ten years.
For BCH, I get the following results:
Intrinsic value per share = $ 21.80
Current Market price = $ 20.3 on Sept 22, 2023
To estimate BCH`s relative value, I choose the following South American banks:
- Banco Santander-Chile ((BSAC))
- Banco Itau Chile ( ITCL )
- Bancolombia ( CIB )
- Banco do Brasil ( BDORY )
- Grupo Galicia ( GGAL )
Seeking Alpha
Using price to book BCH is overpriced, especially compared to its regional peers BDORY and CIB. I assume the market has already priced in BCH`s qualities, and given the adverse macro environment, there is not much upside potential, at least for now.
Risks
The bank-specific risks are well managed. BCH loan composition distributes the credit risk between the lenders. Banco de Chile funds its operations through interbank borrowing, client deposits, and bond issuance, thus having the flexibility to control banks` liquidity risk. Time deposits represent 30% and demand deposits 26%, respectively, giving BCH more control over its liquidity. The bank's operations are prudently managed, too, which is visible from BCH`s excellent metrics.
The more pronounced risk is the declining interest rates. In the long term, they cause NIM compression. The image below shows BCH CPI and interest rate expectations.
Banco de Chile presentation
Such a steep decline in rates has positive effects, too. The non-performing loans ratio (NPL) will remain stable for longer, and the lower the rates, the more enticed individuals and businesses to borrow. BCH fees and commission income represent 27% of the total banks` revenue, thus dampening the effects of NIM contraction.
Conclusion
Holding a Chilean bank—even a strong one like BCH—in the context of declining rates is not attractive, especially without a sufficient margin of safety to protect against potential regulatory gimmicks. However, Banco de Chile deserves to be among its competitors, given its balance sheet quality, excellent efficiency ratio, and outstanding Basel III metrics. I give BCH a hold rating due to interest rate cuts, though I will keep following the Chilean banking system, considering the country`s potential.
For further details see:
Banco de Chile: Excellent Bank At A Fair Price In A Declining Rates Environment