Itaú Is a Sure Bet on Reliable Dividends in Brazil (NYSE:ITUB)

In my opinion Itaú Unibanco Holding (NYSE:ITUB) is the most solid financial institution in Brazil, supported by tradition, a large number of clients and a consistently high net profit. After being acquired by Nu Holdings (NU) It is no longer the largest bank in terms of market capitalization, but it still deserves recognition due to its consolidation and tradition in the banking sector.

This trend continued in Q2 results, with Itaú posting net income of R$10 billion, while Banco do Brasil (OTCPK:BDORY) was its closest competitor with income of R$9.72 billion, Nu Holdings and Banco Bradesco (BBD) did not even reach half of that level.

With high profitability and competitive dividends, the obstacles to Itaú’s thesis are mainly twofold. The first concerns all companies exposed to the Brazilian country scenario, i.e. fiscal, economic and exchange rate risks. The second is the margin of safety, which is no longer as attractive Compared to the last few quarters, Itaú (ITUB4) stock is up 38% over the last 12 months, with the most significant performance being an increase of ~11% since the beginning of August.

Regardless, Itaú shares are trading at a very reasonable level given all of the company’s strengths, making it a move worth considering.

Review of Itaú’s strong second-quarter results

Itaú’s second-quarter earnings were quite strong and solidified its excellent recent performance. In the wake of the pandemic, even in a more competitive environment with fintechs, Itaú has proven its ability to innovate and consistently increased its net income quarter after quarter. This has brought its net income CAGR over the last 5 years to 7.28%, even with an already very high net income volume, compared to the average over the last 20 years of 13.5%.

Operating indicators and improved financial margins with customers and the market drove this net profit. In Q2, Itaú’s total loan portfolio increased by 5.9% compared to Q1, reaching R$ 1.25 trillion, with the most important moment for corporate loans, which increased by 8.9%, and Latin America, which increased by 13.3%, driven by exchange rate factors.

Despite this increase, consolidated 90-day NPL remained stable at 2.7%, while consolidated 15-90-day NPL fell from 2.4% to 2.3%. The renegotiated portion of the portfolio also declined and shrank to 3%, compared to 3.2% in Q1. The coverage ratio fell slightly, from 221% to 215%. Finally, CET I also declined due to higher net income, from 13% to 13.1% (14.6% with additional Tier I). In other words, the main quality metrics are still very solid and provide confidence to shareholders.

In terms of efficiency and profitability indicators, the financial margin with clients increased from R$ 22.8 billion to R$ 23.4 billion, driven by both higher volume and higher spread. Commissions and insurance also increased by 5% compared to Q1, driven by growth of over 33% in advisory and brokerage services. This, combined with good expense management, illustrated by an efficiency ratio that reached 37% in the first half of 2024, meant that the recurring management result reached R$ 10.1 billion, with a return on equity (ROE) of 22.4%.

It is worth mentioning that the bank has guidance for 2024 for loan portfolio growth in the range of 6.5% to 9.5%, financial margin growth with clients in the range of 4.5% to 7.5%, while core non-interest costs grow in line with/below inflation. According to management, it is expected that by the end of this year there will be better vision, outlook and some opportunities which should enable calibration and execution of new (extraordinary) dividend distribution, especially after regulatory uncertainties, discussions on IFRS9 and the like.

“Our expectation is to end the year with a good vision, perspective, four regulatory opportunities, issues, good operation of capital capacity to generate organic capital. So we can calibrate well and make another extraordinary dividend payment. With the information that I have today, the payment will be made. There will be an extraordinary dividend. But we also see as an advantage that we have a very solid capital base because opportunities will arise.”

– Milton Maluhy, CEO of Itaú Unibanco

Itaú stands out in the banking sector

Itaú’s thesis is very different from some of the companies I’ve written about recently, like Nu Holdings and PagSeguro (PAGS). Unlike these fintechs, where the focus is on growth, and in the case of Nu Holding, an attractive valuation is sacrificed, and in the case of PagSeguro, greater security is sacrificed, Itaú’s thesis emphasizes quality and security (without sacrificing all of its growth). Itaú also stands out in terms of quality compared to its traditional peers, with a higher and more consistent ROE than Bradesco and without the sovereign risk of Banco do Brasil.

Selic’s current yield is 10.5%, and since Itaú is a predictable cash cow, many investors believe Itaú shares could yield slightly above this yield, at a similar level, with a small equity risk premium (for example, a yield of 13% per annum in Brazilian reais).

Combining this predictability, higher quality, and lower risk than its main competitors, Itaú trades at a premium. Its price-to-book ratio is 1.7x, which is reasonable for a bank with an ROE above 20%, while Bradesco has 1x and Banco do Brasil 0.9x. The dividend yield for the last 12 months was 5.6%, while BBD was 6.47% and BDORY 7.6%.

In terms of P/E, Itaú also trades above the other two, currently trading at 7.9x, below its 10-year average of 9.1x. It’s worth noting that Itaú has been reporting fairly consistent earnings (i.e., far from its “low” cycle), and barring any negative macro surprises that prevent this progress from continuing, we could expect to see a modest increase through normalization of these multiples.

In other words, this level of valuation “premium” is entirely justified, and eight times earnings for a bank that generates gradually consistent earnings and a monthly dividend yield is an interesting level.

Itaú’s valuation is solid, but it’s no longer a great bargain

In the first graph of Itaú’s net income, you can see that there was some stagnation in net income from mid-2014 to 2019, partly due to the economic crisis. This is the real risk of the thesis that Itaú will not be able to grow its net income at the expected rate due to macroeconomic headwinds. This is even more evident when you look at this in US dollars. Over the last 5 years, the Brazilian Real has devalued (against the US dollar) by ~24%. This makes the position more risky for the US investor and reinforces the caution needed when buying EM stocks. To illustrate, the graph of net income per quarter looks very different in US dollars, with stagnation since mid-2010.

This is a double-edged sword. If the BRL grows strongly, foreign investors will benefit. While this is not the base case scenario – the Brazilian central bank has a more stable exchange rate estimate and problematic fiscal policy, but interest rates are still restrictive and inflation is fine – this could happen because of the cyclical nature of the Brazilian economy, which is directly and indirectly affected by commodity cycles (note the growth of the Brazilian real up until the subprime crisis in 2008).

Given these risks, it is necessary to adopt conservative assumptions when valuing Itaú, both in terms of the bank’s future growth and the discount rate. Historically, Itaú has distributed around 50% of its net income, which already provided an interesting level, with an average dividend per share of $0.32. Currently, these ratios are 58.4% and $0.30, respectively.

Given the risks in Brazil and the less aggressive growth of Itaú’s business (given its consolidation), we will adopt conservative assumptions in the dividend discount model. With next year’s dividend of $0.32 slightly above the current DPS, reflecting the evolution of earnings; a discount rate of 10%, which is an excellent level and already well-paid, even considering the exchange rate risk; and a growth rate of 5%, reasonable given the recent history and the possibility of increasing the payout in stable scenarios. These assumptions reflect a fair price of $6.40 per ITUB share.

This fair price would be slightly lower than the current price, which already shows a margin of safety adjustment. On the other hand, while I consider this price a better entry level, the ~$6.80 the stock is trading at today is also not expensive, and given conservative assumptions, it is still capable of generating shareholder value through dividends.

Final Thoughts

Even after ITUB stock’s earnings, a very conservative dividend discount model is able to find a fair price slightly below, meaning that while the margin of safety isn’t huge, it’s still there. This becomes even more true when you compare it to other alternatives in Brazil, such as Nu Holdings, Petrobras (PBR) or Vale (VALE), which, while good companies, offer more volatility and less predictability compared to Itaú.

Itaú therefore appears to be a safe way to gain exposure to Brazil, which comes with macroeconomic and exchange rate risks, but is partly compensated by monthly dividends and an attractive dividend yield, which helps cover the cost of holding the asset.