Banco do Brasil shares: Q2 shows effect of lower rates, long-term buying (BDORY)

Banco do Brasil’s ( OTCPK:BDORY ) 2Q24 results were in line with their annual guidance, although analysts were concerned about an increase in certificates, challenges in the agricultural segment and a continued decline in margins.

Looking long-term, the company looks strongly positioned to grow with Brazil, being one of the strongest banks in the system. It is not as affected by competition from fintechs and has good average ROE and book growth. The main risk to the stock is the devaluation of the Brazilian real. I think the stock is an opportunity for long-term holders and consider it a Buy at these prices.

2Q24 results

In short, BdoB’s 2Q24 results showed healthy book growth, albeit at declining margins (both gross and net of certificates). The effect of the drop in Brazilian interest rates is being felt. The bank is trying to offset the drop in book margins growth (ie, leverage). Analysts are concerned about the position in the BdoB agricultural segment, with commodity prices collapsing. However, due to the nature of these lines, I don’t see much risk for BdoB in this segment.

Raising the cards: BdoB promised 8% book growth for the year and posted 13% for 1H24. Most of the growth came from agriculture (17%) and business lines (13%), while loans to individuals grew more slowly than the entire book (6%). This is not strange given that BdoB is largely a business bank with a strong focus on subsidized credit for the agricultural and business sectors.

Edge compression: Although gross and net interest income increased (gross up 16%, net up 12%), the results were still worrying. The year-on-year growth is based on smooth year-over-year comparisons, while on a sequential basis the decline in margins, and in particular customer margins, is evident (see image below, yellow for customer margin, blue for customer margin market).

Rates are falling: The decrease in net interest income from customers in 3Q23 coincides with a decrease in the Brazilian benchmark rate in 3Q23. As explained during the call, some of BdoB’s funding comes from debt that is not as sensitive to the federal rate, resulting in margin compression during falling rates and expansion during rising rates.

An eye on agriculture: BdoB is Brazil’s unsurpassed leader in agricultural lending, with a market share reaching 60%. Most of these loans are given at government subsidized rates. The problem some analysts see is falling prices for agricultural commodities (primarily the Brazilian staples of corn and soybeans), which could lead to more delinquencies in the book.

The bank acknowledged that some borrowers are trying to prolong payments as long as possible as they try to avoid selling their crop at these prices. However, the bank is confident it will have to pay to receive funding for next season.

When we look at the historical allocation rates in rural credit for BdoB, they are generally very low. We can clearly see an increase in certificates between 2016 and 2019, but commodity prices are not driving this (they were already low between 2013 and 2016). They have more to do with the Brazilian recession between 2016 and 2021, in my opinion. Today, rates are low but rising and the bank is adjusting upwards, but this seems unlikely to prove a long-term problem.

Long-term analysis

I think BdoB is one of the best run banks in the country. It has a very strong position in agriculture and business based on its dominance of subsidized credit. The bank has recorded impressive levels of return on investment even during the GFC, the Brazilian recession and the pandemic.

Excellent ROE: A characteristic of Brazilian banks is their high profitability, even in difficult times. BdoB is no different, being one of the best of its peers.

Efficient operations: Despite being a publicly controlled bank, BdoB has some of the most efficient operations among Brazilian banks as measured by their efficiency ratio.

Fintech protection: A general thesis against traditional Brazilian banks is that fintech will eat their protected turf through better and cheaper services. I don’t think this is the case with BdoB, which has a business centered on subsidized loans for agriculture and business. Subsidized rates are specifically provided by the government and allow the BdoB to maintain the principalship of the client, not making much of the subsidized loans, but providing other services.

Raising cards in reals only: The bank has steadily grown its book volume, driven in part by the monetization of the Brazilian economy. Brazilian real assets increased from R$1.2 trillion in 2014 to R$2.2 trillion in 2023 (84% or a CAGR of 7%). Brazil’s M3 money supply grew by 130% over the same period. The problem is that this monetization has been offset by a depreciation of the currency. In dollar terms, BDORY assets are basically flat.

Valuation and impairment risk

Today, BDORY trades at a P/B of 0.9. Compared to an average cycle ROE of 16.5%, the bank offers an equity return of 18%. Even if we reduce the average return to one of the lowest in the cycle, 12%, the return on a P/B of 0.9 is still 13%. These numbers are attractive.

In addition, we need to add a loan book growth of 7% CAGR. However, we must incorporate the risk of BRL depreciation. Over the past ten years, the steady depreciation of the BRL has offset the entire increase in BDORY’s local currency assets. Therefore, I believe that this source of growth should not be included in profitability comparisons. On the other hand, between the early 2000s and early 2010s, the BRL appreciated as the Brazilian economy monetized, providing a dual source of USD growth that we do not consider here.

Overall, I think yields between 13% and 18% are attractive for a bank with BDORY’s characteristics, with a strong market position, efficient management and strong ROE numbers. For these reasons, I think the bank is a Buy at these prices.

Editor’s Note: This article discusses one or more securities that are not traded on a major US exchange. Please be aware of the risks associated with these stocks.