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We are upgrading our recommendation on Brazil’s Itau Unibanco Holding S.A., (ITUB - Analyst Report) to Neutral from Underperform, based on its efforts to diversify and reduce its risk profile.

Second Quarter Results

Itau Unibanco’s second-quarter 2012 net income came in at R$3.3 billion ($1.7 billion), below the prior-quarter earnings of R$3.4 billion ($1.9 billion) and year-ago earnings of R$3.6 billion ($2.3 billion). The decline stemmed from elevated levels of provisions for loan losses.

However, excluding non-recurring items, Itaú Unibanco reported second-quarter earnings of R$3.6 billion ($1.8 billion), up 1.2% sequentially and 8.1% year over year on higher operating revenues. The company’s results reflect the impact of rising default levels in the Brazilian economy, resulting in credit quality deterioration.

Our Viewpoint
Itau Unibanco’s solid business model, a diversified product mix, growing service fees and expanded credit portfolio are impressive. As a premier banking brand in Brazil, Itau Unibanco Holding has a large branch network in geographic areas where economic activities are high.

However, weak asset quality remains a major concern for Itau Unibanco. Given the company's rapid loan growth over the last five years and expansion into lower-income markets (such as individuals and micro, small, and mid-sized companies) we expect asset quality metrics to remain stretched and loan loss provisions to remain at elevated levels in the upcoming quarters

The vehicle loan category is experiencing a significant increase in default levels, and this remains a concern as it constitutes a significant portion of the company’s total credit portfolio.

To address such issues, Itau Unibanco is lowering its credit portfolio of car financing from R$60 billion by the end of 2011 to R$50 million–R$52 billion in 2012. Moreover, the company’s move to boost the low risk payroll deductible loans business across the country is a strategic fit.

Recently, Itau Unibanco Holding SA, through its subsidiary, Itau Unibanco S.A. entered into a joint venture (JV) agreement with Banco BMG S.A. In this JV, Itau Unibanco will have a 70% controlling stake while BMG will hold the remaining 30%.

The company expects its JV to originate a total payroll loan portfolio of R$12 billion in the next two years. The deal would also help it offer its banking products to approximately 3 million new customers.

Notably, payroll deductible loans refer to loans that are being offered to clients who have a payroll account, where their salaries are deposited in the bank offering the loan. The bank has the authority to deduct the monthly installments directly from the payroll account; hence, such loans bear low risk and the chances of default is also less.

However, besides asset quality concerns, increasing competition and the stressed conditions in the Brazilian economy pose as risks. Hence, we find the risk/reward profile for Itau Unibanco somewhat balanced and hence have upgraded its long term recommendation to Neutral.

Itau Unibanco’s shares retain a Zacks #4 Rank, which translates into a short-term Sell recommendation. Its closest peer Banco Bradesco S.A. (BBD - Snapshot Report) retains a Zacks #3 Rank, implying a short term Hold recommendation.

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