Financials Credit Analyst

Hank Calenti, CFA

CreditContinuum

Credit

We have been here before. As the Fed places achieving full employment above its goal of stable and low inflation, risks to financial stability should rise. Stability may be threatened by asset bubbles which are already likely to be forming in asset markets.At the same time, the fear of missing out (FOMO) is pushing investors to be invested while herd mentality provides job protection for asset managers that remain invested. The risk of an equity correction grows in the background. The issue is the lack of a catalyst for now. However, when it does arrive, the question is whether it is accompanied by a flight to quality in the bond market or if rising inflation expectations keep pushing market interest rates higher. Correlations may be reset in the latter outcome and some asset managers could implode in that scenario.We have been here before, as well. Counterparty failures and concerns regarding central clearing house stability may be the hot topics by the end of the year. As such, credit analysts should re-assess their exposures to the former, the prime brokers. Concurrently, now would be an opportune time to buy protection via credit indexes or credit default swaps. Most asset managers will not, as they are protected by the herd, but fortune favors the brave.In the near term, the market is gaining a newfound appreciation for the obscure mechanisms that influence short-term interest rates. We do our best to explain these tools inside and for more background on these pressures, please see our most recent <a href="https://www.smartkarma.com/insights/bank-macro-manifest-risk-rally-gathers-steam-as-bad-news-more-stimulus" target="_blank" data-smartkarma-citation="insights:47886" rel="noopener">Bank Macro Manifest: Risk Rally Gathers Steam as Bad News = More Stimulus</a>. More importantly, this concern is new and something new creates an opportunity. This is where the price of protection could be earned.Only the patina of time will tell if we are right in our correlation and counterparty concerns. But why risk it? Now is the time to think outside the box. Credit investors are not just playing for carry. Price appreciation may be gone, but credit investors need to play for highly efficient carry. Emerging Market and other High Yield assets will likely be impacted by the dislocation in short-term interest rates as investors bid-up higher yielding, short duration assets. A melt-up should occur before we get to the eventual meltdown. This is where to position.As such we identify our top 10 bank securities to position within to ride the melt-up. Downside risks are limited to potential opportunity costs from not investing further out the curve. However, we suspect that many investors are already full of long duration positions. The upside is that, if we are correct, these securities could also outperform in a meltdown. Therefore, our top melt-up picks may dovetail with attempts to reduce duration as the year proceeds.

We have been here before. As the Fed places achieving full employment above its goal of stable and low inflation, risks to financial stability should rise. Stability may be threatened by asset bubbles which are already likely to be forming in asset markets.At the same time, the fear of missing out (FOMO) is pushing investors to be invested while herd mentality provides job protection for asset managers that remain invested. The risk of an equity correction grows in the background. The issue is the lack of a catalyst for now. However, when it does arrive, the question is whether it is accompanied by a flight to quality in the bond market or if rising inflation expectations keep pushing market interest rates higher. Correlations may be reset in the latter outcome and some asset managers could implode in that scenario.We have been here before, as well. Counterparty failures and concerns regarding central clearing house stability may be the hot topics by the end of the year. As such, credit analysts should re-assess their exposures to the former, the prime brokers. Concurrently, now would be an opportune time to buy protection via credit indexes or credit default swaps. Most asset managers will not, as they are protected by the herd, but fortune favors the brave.In the near term, the market is gaining a newfound appreciation for the obscure mechanisms that influence short-term interest rates. We do our best to explain these tools inside and for more background on these pressures, please see our most recent Bank Macro Manifest: Risk Rally Gathers Steam as Bad News = More Stimulus. More importantly, this concern is new and something new creates an opportunity. This is where the price of protection could be earned.Only the patina of time will tell if we are right in our correlation and counterparty concerns. But why risk it? Now is the time to think outside the box. Credit investors are not just playing for carry. Price appreciation may be gone, but credit investors need to play for highly efficient carry. Emerging Market and other High Yield assets will likely be impacted by the dislocation in short-term interest rates as investors bid-up higher yielding, short duration assets. A melt-up should occur before we get to the eventual meltdown. This is where to position.As such we identify our top 10 bank securities to position within to ride the melt-up. Downside risks are limited to potential opportunity costs from not investing further out the curve. However, we suspect that many investors are already full of long duration positions. The upside is that, if we are correct, these securities could also outperform in a meltdown. Therefore, our top melt-up picks may dovetail with attempts to reduce duration as the year proceeds. 

Bank Credit Strategy: Melt-Up Before Meltdown, Where to Position

Financials & FinTech research, Galliano’s Financials Research

Victor Galliano

Financials & FinTech research

Financials & FinTech, EM & Developed Markets

Galliano’s Financials Research

Galliano's Financials Research provides fundamental research in Emerging Markets financials, including FinTech, as well as financials in select Developed Markets.

The investment style applied is generally value oriented, although Growth At Reasonable Price (GARP) strategies can also be used where appropriate. 

Our investment research approach aim is often contrarian, looking to capitalise on overly sceptical or optimistic consensus views. In terms of valuation techniques, the focus is on PBV ratio to ROE, PE multiples and dividend yield, as well as the application of PEG ratios and, where appropriate, Sum of the Parts (SOTP) valuations.

Equity Bottom-Up

<ul>
<li>The system ended the year with an NPL ratio of 2.1% and NPL coverage of 295%, in Brazilian GAAP terms, as shown in Figures 5 and 10 in this report</li>
<li>Although these headline NPL ratios and coverage for the bank sector at December 2020 look reassuring, they are, in our view, not the optimal metric for credit risk going forward</li>
<li>We note that early delinquency indicators, which often act as a leading indicator for headline NPLs, are starting to rise as the pandemic mandated grace period ends for the bulk of renegotiated loans, as seen in Figure 9</li>
<li>System data to December 2020 shows that household loan renegotiations have risen sharply, and in 4Q20 delinquencies on renegotiated loans have, as shown in Figure 8, started to rise</li>
<li>The Brazilian household debt service ratio is rising and the debt burden is at a 13 year high, as shown in Figures 13 and 14</li>
<li>The largest three private sector banks in Brazil have reported 4Q20 results, and we compare some credit quality metrics; in the cases of <a href="https://www.smartkarma.com/entities/itau-unibanco-holding-sa-9d47d196-e503-471b-a84e-ca4401033062" target="_blank" data-smartkarma-citation="entities:24550:1" rel="noopener">Itau Unibanco Holding Sa (ITUB4 BZ)</a>, <a href="https://www.smartkarma.com/entities/banco-santander-brasil-sa" target="_blank" data-smartkarma-citation="entities:27709:1" rel="noopener">Banco Santander Brasil SA (SANB11 BZ)</a> and <a href="https://www.smartkarma.com/entities/banco-bradesco-sa" target="_blank" data-smartkarma-citation="entities:24569:1" rel="noopener">Banco Bradesco Sa (BBDC4 BZ)</a>, we believe that the low domestic GAAP NPL ratios may not be an accurate reflection of the credit risk outlook, so we compare these with the central bank defined D-H poor credit quality “buckets” in Figure 2, and the D-H coverage ratio</li>
<li>We conclude that on D-H share of total loans and coverage, Itau Unibanco’s Brazilian operations screen best, despite having the highest Brazil GAAP NPL ratio in 4Q20; Bradesco has the highest D-H share of total loans, and the lowest D-H coverage along with Santander Brasil</li>
<li>Risks to our positive view on Itau Unibanco include a worse than expected outcome on Brazilian credit quality for Itau in Brazil and its non-Brazilian LatAm operations, thereby raising pressure on their cost of risk outlook</li>
</ul>


The system ended the year with an NPL ratio of 2.1% and NPL coverage of 295%, in Brazilian GAAP terms, as shown in Figures 5 and 10 in this report
Although these headline NPL ratios and coverage for the bank sector at December 2020 look reassuring, they are, in our view, not the optimal metric for credit risk going forward
We note that early delinquency indicators, which often act as a leading indicator for headline NPLs, are starting to rise as the pandemic mandated grace period ends for the bulk of renegotiated loans, as seen in Figure 9
System data to December 2020 shows that household loan renegotiations have risen sharply, and in 4Q20 delinquencies on renegotiated loans have, as shown in Figure 8, started to rise
The Brazilian household debt service ratio is rising and the debt burden is at a 13 year high, as shown in Figures 13 and 14
The largest three private sector banks in Brazil have reported 4Q20 results, and we compare some credit quality metrics; in the cases of Itau Unibanco Holding Sa (ITUB4 BZ), Banco Santander Brasil SA (SANB11 BZ) and Banco Bradesco Sa (BBDC4 BZ), we believe that the low domestic GAAP NPL ratios may not be an accurate reflection of the credit risk outlook, so we compare these with the central bank defined D-H poor credit quality “buckets” in Figure 2, and the D-H coverage ratio
We conclude that on D-H share of total loans and coverage, Itau Unibanco’s Brazilian operations screen best, despite having the highest Brazil GAAP NPL ratio in 4Q20; Bradesco has the highest D-H share of total loans, and the lowest D-H coverage along with Santander Brasil
Risks to our positive view on Itau Unibanco include a worse than expected outcome on Brazilian credit quality for Itau in Brazil and its non-Brazilian LatAm operations, thereby raising pressure on their cost of risk outlook


Brazil Banks YE 2020 Snapshot: Itau (ITUB4 BZ) Well Positioned to Confront Tougher Credit Quality

Equity Capital Markets

<ul>
<li>In the follow-on issue, the primary portion announced by <a href="https://www.smartkarma.com/entities/xp-inc" target="_blank" data-smartkarma-citation="entities:28619:1" rel="noopener">XP Inc (XP US)</a>  is small relative to its current market value (c 1.5%), but coupled with the Itaú partial disposal of a maximum 4.3% stake in XP, it creates a clear share over-hang</li>
<li>In addition, <a href="https://www.smartkarma.com/entities/itau-unibanco-holding-sa-9d47d196-e503-471b-a84e-ca4401033062" target="_blank" data-smartkarma-citation="entities:24550:1" rel="noopener">Itau Unibanco Holding Sa (ITUB4 BZ)</a>’s spin-off of its remaining stake in XP (c 41.2% post follow-on) into single-purpose company named NewCo was approved by its board on 26th November, and shares in the forthcoming NewCo are exempt from any lock-up agreement</li>
<li>HoldCo <a href="https://www.smartkarma.com/entities/itausa-investimentos-itau-pr" target="_blank" data-smartkarma-citation="entities:24513:1" rel="noopener">Itausa-Investimentos Itau-Pr (ITSA4 BZ)</a> will become a large shareholder in XP post Itaú Unibanco’s spin-off, and although it has stated that it does not intend to dispose of its stake in the short term, Itausa does not consider the XP stake as a long term, strategic holding</li>
<li>The spin-off, lack of lock-up for spun-off shares and Itausa’s non-strategic classification of its XP holding creates further medium term over-hang for XP shares, in our view, post the follow-on issue; add to this the challenging fundamental outlook (especially related to the IFA “arms race”) and XP’s demanding valuations, it all contributes to our caution on XP shares</li>
<li>We prefer indirect, and diluted, exposure through holdco Itausa, in which we estimate Itausa will have an 15.6% economic stake in XP post follow-on issue and NewCo formation</li>
<li>Risks to our view include better than expected fundamental performance by XP, and less than expected pressure on costs related to incentives for IFAs, which would continue to drive premium growth and justify the premium multiples, and smaller than expected secondary share offerings in XP over the medium term</li>
</ul>


In the follow-on issue, the primary portion announced by XP Inc (XP US)  is small relative to its current market value (c 1.5%), but coupled with the Itaú partial disposal of a maximum 4.3% stake in XP, it creates a clear share over-hang
In addition, Itau Unibanco Holding Sa (ITUB4 BZ)’s spin-off of its remaining stake in XP (c 41.2% post follow-on) into single-purpose company named NewCo was approved by its board on 26th November, and shares in the forthcoming NewCo are exempt from any lock-up agreement
HoldCo Itausa-Investimentos Itau-Pr (ITSA4 BZ) will become a large shareholder in XP post Itaú Unibanco’s spin-off, and although it has stated that it does not intend to dispose of its stake in the short term, Itausa does not consider the XP stake as a long term, strategic holding
The spin-off, lack of lock-up for spun-off shares and Itausa’s non-strategic classification of its XP holding creates further medium term over-hang for XP shares, in our view, post the follow-on issue; add to this the challenging fundamental outlook (especially related to the IFA “arms race”) and XP’s demanding valuations, it all contributes to our caution on XP shares
We prefer indirect, and diluted, exposure through holdco Itausa, in which we estimate Itausa will have an 15.6% economic stake in XP post follow-on issue and NewCo formation
Risks to our view include better than expected fundamental performance by XP, and less than expected pressure on costs related to incentives for IFAs, which would continue to drive premium growth and justify the premium multiples, and smaller than expected secondary share offerings in XP over the medium term


XP (XP US) Follow-On Issue Highlights Over-Hang, Potential for More Share Sales Post Itaú Spin-Off

<ul>
<li>We believe that 2021 and 2022 consensus EBITDA and net earnings estimates for <a href="https://www.smartkarma.com/entities/xp-inc" target="_blank" data-smartkarma-citation="entities:28619:1" rel="noopener">XP Inc (XP US)</a> are too aggressive</li>
<li>XP’s “investment” in the IFA network is set to continue into 2021, in our view, to counter growing competition, largely from BTG Pactual where an IFA “arms race” seems to be brewing</li>
<li>XP’s September announcement to eliminate trading fees at Rico and to sharply reduced them at XP direct, although barely expected to impact revenue, is a sign of greater competitive pressures, mainly from other digital players</li>
<li>There is a cost outlay to broaden out XP’s suite of financial products, like credit cards, that will add to opex in 2021</li>
<li>We still expect XP to deliver strong growth, but based on our CAGR for EBITDA and net earnings, the EVG of 1.16x and PEG ratio of 1.84x look stretched</li>
<li>In addition, there is the stock overhang from <a href="https://www.smartkarma.com/entities/itau-unibanco-holding-sa-9d47d196-e503-471b-a84e-ca4401033062" target="_blank" data-smartkarma-citation="entities:24550:1" rel="noopener">Itau Unibanco Holding Sa (ITUB4 BZ)</a>’s planned disposal of a 5% stake in XP, as well as the potential rotation from tech to value that could pressure XP’s premium multiples</li>
<li>Risks to our bearish view on XP include stronger than expected asset inflows, successful opex control and a rebound in the take rate from retail operations</li>
</ul>


We believe that 2021 and 2022 consensus EBITDA and net earnings estimates for XP Inc (XP US) are too aggressive
XP’s “investment” in the IFA network is set to continue into 2021, in our view, to counter growing competition, largely from BTG Pactual where an IFA “arms race” seems to be brewing
XP’s September announcement to eliminate trading fees at Rico and to sharply reduced them at XP direct, although barely expected to impact revenue, is a sign of greater competitive pressures, mainly from other digital players
There is a cost outlay to broaden out XP’s suite of financial products, like credit cards, that will add to opex in 2021
We still expect XP to deliver strong growth, but based on our CAGR for EBITDA and net earnings, the EVG of 1.16x and PEG ratio of 1.84x look stretched
In addition, there is the stock overhang from Itau Unibanco Holding Sa (ITUB4 BZ)’s planned disposal of a 5% stake in XP, as well as the potential rotation from tech to value that could pressure XP’s premium multiples
Risks to our bearish view on XP include stronger than expected asset inflows, successful opex control and a rebound in the take rate from retail operations


XP (XP US): Competition Headwinds to Persist

Event-Driven

<ul>
<li>
<a href="https://www.smartkarma.com/entities/itau-unibanco-holding-sa-9d47d196-e503-471b-a84e-ca4401033062" target="_blank" data-smartkarma-citation="entities:24550:1" rel="noopener">Itau Unibanco Holding Sa (ITUB4 BZ)</a> is to restructure most of its holding in <a href="https://www.smartkarma.com/entities/xp-inc" target="_blank" data-smartkarma-citation="entities:28619:1" rel="noopener">XP Inc (XP US)</a>, NASDAQ listed fintech, via spin-off</li>
<li>Itaú registered positive 3Q20 results; Itaú also plans to dispose of a 5% stake in XP, which should bolster core capital ratios</li>
<li>We had been cautious on <a href="https://www.smartkarma.com/entities/itausa-investimentos-itau-pr" target="_blank" data-smartkarma-citation="entities:24513:1" rel="noopener">Itausa-Investimentos Itau-Pr (ITSA4 BZ)</a>, but we now identify it as an attractive vehicle through which to play its main holding in Itaú Unibanco and the XP spin-off</li>
<li>The XP spin-off – NewCo – which is expected to take place in 1Q21, will be listed on Bovespa, giving NewCo shareholders market liquidity</li>
<li>We estimate that Itausa’s NAV discount has widened to 24%, which is attractive versus its NAV discount history</li>
<li>We also believe the NAV discount should narrow structurally, as the listed NewCo will provide Itausa with (potentially discounted) exposure to a listed FinTech vehicle, along with the scope for dividend recovery at Itaú Unibanco</li>
<li>In essence, we expect shareholder value creation from the XP stake spin-off for both Itaú Unibanco but also for the discounted holding Itausa</li>
<li>Risks include delays and in the extreme the suspension of the XP NewCo spin-off, and the potential for worse than expected fundamental performance at Itausa’s core holding, Itaú Unibanco</li>
</ul>



Itau Unibanco Holding Sa (ITUB4 BZ) is to restructure most of its holding in XP Inc (XP US), NASDAQ listed fintech, via spin-off
Itaú registered positive 3Q20 results; Itaú also plans to dispose of a 5% stake in XP, which should bolster core capital ratios
We had been cautious on Itausa-Investimentos Itau-Pr (ITSA4 BZ), but we now identify it as an attractive vehicle through which to play its main holding in Itaú Unibanco and the XP spin-off
The XP spin-off – NewCo – which is expected to take place in 1Q21, will be listed on Bovespa, giving NewCo shareholders market liquidity
We estimate that Itausa’s NAV discount has widened to 24%, which is attractive versus its NAV discount history
We also believe the NAV discount should narrow structurally, as the listed NewCo will provide Itausa with (potentially discounted) exposure to a listed FinTech vehicle, along with the scope for dividend recovery at Itaú Unibanco
In essence, we expect shareholder value creation from the XP stake spin-off for both Itaú Unibanco but also for the discounted holding Itausa
Risks include delays and in the extreme the suspension of the XP NewCo spin-off, and the potential for worse than expected fundamental performance at Itausa’s core holding, Itaú Unibanco


Itausa (ITSA4 BZ): Discounted Access to Itaú Unibanco, and Potentially to the XP Holding Spin-Off

Brazil

Itaú Unibanco Holding S.A. is a Brazilian multinational financial conglomerate and the largest bank in Latin America by market value. It offers a comprehensive suite of financial products and services, including retail and wholesale banking, investment banking, asset management, and insurance to individual and corporate clients. The company is headquartered in São Paulo, Brazil, and traces its origins to 1924, with the merger of Banco Itaú and Unibanco forming the current entity in 2008.

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Itau Unibanco (ITUB4 BR)

Bank Credit Strategy: Melt-Up Before Meltdown, Where to Position

We could see a melt-up in asset prices from short-term interest rate pressures before the eventual meltdown. We explain the melt-up potential and...

Hank Calenti, CFA

Brazil Banks YE 2020 Snapshot: Itau (ITUB4 BZ) Well Positioned to Confront Tougher Credit Quality

Investors should look beyond the headline NPL ratios and coverage for Brazilian banks; we conclude that on the D-H share of loans and coverage,...

Victor Galliano

XP (XP US): Competition Headwinds to Persist

Brazil fintech XP is in an IFA "arms race" with brokerage competitors that threatens its premium EBITDA growth and its stretched multiples; also...

Victor Galliano

Itausa (ITSA4 BZ): Discounted Access to Itaú Unibanco, and Potentially to the XP Holding Spin-Off

Our prior caution on Itausa has turned to enthusiasm; Itausa gives investors discounted access, at a 24% discount to the NAV, to Itau Unibanco and...

Victor Galliano

Price Gauge

52-week Range

Market Cap (USDm)

P/E

Dividend (Yield)

Bank Credit Strategy: Melt-Up Before Meltdown, Where to Position

We could see a melt-up in asset prices from short-term interest rate pressures before the eventual meltdown. We explain the melt-up potential and...

Hank Calenti, CFA

Brazil Banks YE 2020 Snapshot: Itau (ITUB4 BZ) Well Positioned to Confront Tougher Credit Quality

Investors should look beyond the headline NPL ratios and coverage for Brazilian banks; we conclude that on the D-H share of loans and coverage,...

Victor Galliano

XP (XP US) Follow-On Issue Highlights Over-Hang, Potential for More Share Sales Post Itaú Spin-Off

Post XP's follow-on, we see the spin-off, lack of lock-up for spun-off shares and Itausa’s non-strategic view of its XP shares adding to risk of...

Victor Galliano

XP (XP US): Competition Headwinds to Persist

Brazil fintech XP is in an IFA "arms race" with brokerage competitors that threatens its premium EBITDA growth and its stretched multiples; also...

Victor Galliano

Itausa (ITSA4 BZ): Discounted Access to Itaú Unibanco, and Potentially to the XP Holding Spin-Off

Our prior caution on Itausa has turned to enthusiasm; Itausa gives investors discounted access, at a 24% discount to the NAV, to Itau Unibanco and...

Victor Galliano