2023-04-16 06:11:26 ET
Summary
- The interest rate differential and political uncertainty indicate weakness in the Chilean Peso. However, the inflation differential and current account forecasts signal a stronger Peso.
- Earnings in local currency are likely to return to the pre-2022 level.
- The current dividend level implies a 10.8% dividend yield. Even a 40% dividend cut will give a dividend yield that’s over 6%.
- Valuation multiples show that BCH is undervalued.
Banco De Chile (NYSE: BCH ) currently appears quite attractive because of a hefty dividend yield and obvious undervaluation. However, the exchange rate presents a big risk to investment in this American depository share. Further, political uncertainty, especially in the area of taxation on the copper industry, adds to the risks. Considering these factors, I’m adopting a buy rating on Banco De Chile. However, I believe this ADS is unsuitable for low-risk-tolerant investors because of the high-risk level.
Exchange Rate is the Biggest Risk Factor
The biggest drawback of investing in the ADS of Banco De Chile over the last five years has been the depreciation of the Chilean Peso (Ch$) against the U.S. Dollar (US$).
ca.investing.com
The exchange rate has improved over the last few months, but the risk of the Peso’s depreciation remains. The following factors will have a mixed impact on the exchange rate going forward.
1. Future Interest Rate Differential Could Further Depreciate the Peso
Chile’s monetary policy rate (“MPR”) has remained unchanged at 11.25% since October 2022. As stated in the last monetary policy statement , and reiterated by the Chile Central Bank President in a recent interview , the central bank’s board intends to hold the MPR stable until macroeconomic conditions indicate that inflation is well on its way to converging with the target of 3%. The inflation was reported at 11.1% for March 2023, which is well above the target. The board expects the inflation target to be achieved in the latter part of 2024. Further, the IMF in April’s World Economic Outlook database projects inflation to average 4.0% in 2024 and 3.0% in 2025. Therefore, I’m expecting the MPR to remain unchanged in 2023. I’m more optimistic than the management of Banco De Chile, which has incorporated a monetary easing cycle starting from 2Q23 in its earnings guideline, as mentioned in the earnings presentation .
In contrast to the Chilean MPR, I’m expecting the fed funds rate to rise by a further 25-50 basis points by the mid of this year, before plateauing. This would mean a total increase in the fed funds rate of 75-100 basis for the full year of 2023. As a result, the parity between the two interest rates will contract this year, and consequently maintain pressure on the Chilean peso.
The following chart shows the history of the two monetary policy rates.
2. Inflation Differential is in Favor of the Chilean Peso
The difference between the inflation rates of Chile and the U.S. will likely move in favor of the Chilean Peso this year. Inflation in Chile has fallen sharply over the last few months in response to the previous monetary tightening, and it looks like the central bank’s inflation target will be achieved by next year. In comparison, inflation in the U.S. is moving slower.
The following chart shows the inflation history of the two countries. Further, it includes IMF’s projected inflation.
Banco Central Chile and U.S. Bureau of Labor Statistics for History. IMF for Forecasts.
3. Political Uncertainty Could Pressurize the Peso
There is currently some noise on Chile’s political front because the country is in process of drafting a new constitution. The last attempt at drafting the constitution was rejected by voters in September ( news source ). Further, the Chilean government is currently in discussion with copper mining companies over planned tax and royalty changes ( news source ). According to a study by Fitch Ratings , the tax burden could increase by 5% to reach 42% without significantly hurting the industry. Copper is Chile’s top export product, so policy changes in this sector will have wide-ranging implications for the entire Chilean economy, and consequently, the exchange rate, which brings me to the next point.
4. Chile’s Current Account Deficit is Moving in the Right Direction
Due to the slump in copper production, Chile’s exports have declined over the last two years. IMF expects exports to turn around and grow by 2% in 2023 and 5% in 2024. I believe the outlook on Chile’s copper exports is bright because of the green push all over the world and the move towards electric cars. However, exports may be slow to recover this year due to the possibility of a mild recession in the U.S. Fitch Ratings expects the Chilean current account deficit to narrow from 9.3% in 2022 to 5.1% in 2023, while IMF expects it to narrow to 4.2% in 2023.
The IMF projects the Chilean Peso per international dollar, on an implied PPP conversion basis, to flatten, as shown below.
IMF for forecasts. Investing.com and IMF for history.
Considering these factors, I believe the Chilean Peso would remain rangebound this year, before resuming its natural depreciation from next year.
The Earnings Outlook in Local Currency Remains Satisfactory
Banco De Chile’s loan portfolio grew by a strong 7.2% rate over the last four quarters in Ch$ terms, according to details given in the presentation. The management is targeting loan growth to be in line with inflation, so satisfactory growth can be expected for this year as well. (Inflation forecast is given in the section above). On the other hand, the management expects a net interest margin of around 4.3% for 2023, down sharply from 5.5% in 2022.
In my opinion, the balance sheet growth should be high enough to compensate to a large extent for a shrinkage in margins. I don’t think last year’s extraordinary earnings performance can be repeated this year, but BCH’s profits in Ch$ should be comparable to the years before 2022. The management also expects a decent return on average equity of 18% for 2023, which is below the phenomenal level of 2022, but still high compared to previous years.
4Q 2022 Earnings Presentation
The street consensus curated by Seeking Alpha indicates expected earnings of US$2.40 per ADS for 2023, down from last year’s US$3.28, but still much higher than the earnings for 2021 and before.
Dividend Yield of Over 10%, But Payout Ratio is Uncomfortable
Banco De Chile’s current annual dividend of US$2.15 per ADS and the closing price of April 14 imply a huge dividend yield of 10.8%. However, this dividend level is very close to the consensus earnings of US$2.40 per ADS; therefore, there is a threat of a dividend cut. The following sensitivity table shows that even a 40% cut in the dividend will provide a high dividend yield of over 6%.
Reduction in Dividend | - | 10.0% | 20.0% | 30.0% | 40.0% |
Dividend per ADS (US$) | 2.15 | 1.94 | 1.72 | 1.51 | 1.29 |
Consensus Earnings (US$) | 2.40 | 2.40 | 2.40 | 2.40 | 2.40 |
Payout Ratio | 90% | 81% | 72% | 63% | 54% |
Dividend Yield | 10.8% | 9.7% | 8.7% | 7.6% | 6.5% |
Source: Street Consensus from Seeking Alpha, Author's Calculations |
Valuation Multiples Show BCH is Quite Undervalued
Banco De Chile is currently trading at a price-to-tangible book (P/TB) multiple that is much below its historical average, as shown below. Therefore, the stock appears undervalued.
The trailing price-to-earnings (P/E) multiple also shows that the company is currently undervalued from a historical perspective. However, the forward multiple indicates that the stock is fairly valued in the market.
Conclusion: BCH is a Buy, But Not for All Types of Investors
Based on the dividend yield and the current undervaluation from a historical perspective, I’m adopting a buy rating on Banco De Chile. However, this ADS carries high risk because of exchange rate fluctuations and political uncertainty in Chile. As a result, I believe Banco De Chile is unsuitable for low-risk-tolerant investors.
For further details see:
Banco De Chile: Undervalued With A 10% Plus Dividend Yield, But Risks Are High