Description

At the current price of R$ 5.40 Banrisul (BRSR6 BZ on Bloomberg) stock offers the opportunity to buy an overcapitalized regional retail bank with a dominant franchise at an attractive valuation. Banrisul trades at 4 times earnings, 80% of book value, and  12% dividend yield, a significant discount to its larger peers. Long term, Brazil is a country with very attractive banking fundamentals.

Capitalization

Price           R$5.40

Shares         409 million

Mkt Cap     R$ 2,208 million

Description

Banrisul is a regional retail bank controlled by the State of Rio Grande do Sul, the fourth richest state in Brazil with a population of 11 million people. Banrisul was founded in 1928 as a state controlled bank, and, through the consolidation of several state controlled banks (most importantly the state development bank in 1992 and Caixa Estadual and CEE in 1997) became the largest retail bank in the State.

In 1998, due to years of bad lending practices and general mismanagement, Banrisul became insolvent. It was recapitalized under PROES, a federally sponsored program to restructure the States’ banking systems. In addition to the capital injection, the program forced extensive changes to internal controls and corporate governance and opened the door for an eventual privatization in July 2007. The State reduced its participation in the bank from 99% to 57% through the combined sale of existing and new shares.

Banrisul benefits from a privileged retail franchise which has enabled it to earn a very high return on equity (high teens, low 20’s) despite having a high BIS ratio, 18% in the most recent quarter.  The pillars of this competitive position are a low cost, stable funding base and dominant positions in two niche lending businesses: payroll lending and working capital financing of small and medium enterprises.

Banrisul has a sizable base of 2.9 million retail clients which enables it to fund itself at 92 to 93% of the inter-bank rate. Although small relative to the three largest Brazilian banks (ie Itau, Bradesco, Banco do Brasil), it benefits from having the largest retail network in the State.

As of 3Q08, Banrisul had R$ 24 billion in assets, R$ 7 billion in cash, R$ 10.5 billion of gross loans, R$ 9.6 billion of net loans, R$13.9 billion in deposits, and R$ 3 billion in book value. ROE for the quarter was 16%. NPL’s stood at 3.2%. Reserves to non performing loans stood at 275%. Charge offs to average loans were 2.3%. BIS ratio was 18%.  The total assets:equity ratio was 8: 1.

Consumer loans outstanding at 3Q08 were R$3.7 billion. Roughly two thirds of these consist of relatively low risk, high return payroll loans. As part of its payroll management business, Banrisul enters into exclusive contracts that enable it to lend to its clients’ employees and to deduct the payments directly from the employee’s paychecks, thus greatly reducing collection risk.

As the official agent of the state of Rio Grande do Sul, Banrisul does payroll management for all active and retired public sector employees. It also handles exclusively, tax collections and payments to suppliers of the state.

SME loans outstanding were R$5.3 billion. These are heavily weighted towards working capital loans and pre-payments of receivables. Here the bank’s distribution network and its ability to pre-pay receivables originated through its proprietary debit card, Banricompras, provide an important competitive advantage. Banricompras is one of the most actively used debit cards in the State. The rest of the loan book consisted of R$.7 billion in Agricultural loans and R$ .9 billion of mortgages.

Banrisul has maintained an ROE’s in the high to mid teens despite having a high BIS ratio and an inflated cost income ratio at 61%.  Asset quality is high. Reserves are consistently high relative to the level of non-performing loans and provisions consistently exceed charge offs.

Operating metrics

Valution

Banrisul stock is interesting because it enables one to invest in a well capitalized bank with an attractive retail franchise at a significant discount to the large Brazilian private sector banks. It is inexpensive on an absolute and on a relative basis. Banrisul is a fraction of the size of its peers that operate on a national level, and it is controlled by the state. Therefore, it should trade at a discount. But the discount appears  excessive. It trades at .8x book versus 2.4x for Itau, 2.2x for Bradesco, and 1.3x for Banco do Brasil, the largest publicly traded state controlled bank.

Banrisul’s ROE has historically been in the high teens low 20% versus 25% for its large private and public sector peers. However, its tier 1 ratio, a measure of capital adequacy, is 18% versus 11% for the peer group.

As one can see from the table below, asset quality has been better than that of its largest peers.

At the current stock price, an investment in Banrisul combines four qualities: a low valuation, a high return on investment, a strong balance sheet, and logn term earnings  growth prospects.

Growth Opportunities

Management has embarked on an ongoing cost cutting program which encourages employees to opt for early retirement, targeting to reduce the cost to income ratio from the current 61% to a level closer to its peers around 52%.

There is room to grow fee income from the current 24% of total income to the 30% plus level achieved by the private sector banks. Management is addressing this issue by introducing new products, targeting cross selling opportunities, and raises prices of products for which it believes it is under charging.

Banrisul’s high BIS ratio (18%), low assets: equity ratio (8:1) and low loan to  deposit ratio (60%) are all supportive of long term loan growth. As the balance sheet growth, the bank will realize the benefit of operating leverage.

Risks

The biggest risk in the near term is a slowdown in loan growth accompanied by deterioration in asset quality. This is likely to happen in 2009, but it is largely discounted in current earnings estimates.  On the positive side, Banrisul is not coming off an extended period of excessive loan growth. Rio Grande do Sul in 2005 suffered a drought that led to a 5.4% contraction in the States’ GDP versus 2.3% growth in Brazil’s GDP that year. 2005 and 2006 were years of very low loan growth and a slight deterioration for asset quality. Loan growth did not resume until  2007.

Government mismanagement is not currently an issue, but one should monitor the relationship between Banrisul, and its controlling shareholder. In Brazil one has been able to generate attractive returns by investing in state controlled companies. Over time,  management, governance and transparency have improved rather than deteriorated in companies such as Petrobras, Cemig, Telebras, Banco do Brasil. These companies had poor disclosure and mediocre capital allocation fifteen years ago, but surprises have been to the upside in terms of improvements and the realization of hidden assets. This is Rio Grande do Sul’s first privatization, and the State government is interested in doing more in order to reduce the fiscal deficit. Furthermore, the State continues to be the largest shareholder.

Banrisul’s exclusive payroll management contract expires in 2011. It is not certain that it will be renewed.

The stock does not trade very well. This is a busted IPO and foreigners own 75% of the free float. There is an overhang, and local investors are aware of it therefore reluctant to buy the stock.

Management has not yet delivered on its plan. It remains to be seen whether management is capable of executing its plan.

Catalyst