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Provisions Pull Down Itau Profit

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Brazil’s Itau Unibanco Holding S.A.’s (ITUB - Free Report) 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.

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.

Itau Unibanco’s results reflect the impact of rising default levels in the Brazilian economy, resulting in credit quality deterioration. The company recorded higher levels of provision expenses, and this led to a fall in the company’s profitability. However, on the positive side, the company grew its operating revenues modestly.

Operating revenues of R$20.3 billion ($10.4 billion) at Itau Unibanco were up 1.8% sequentially and 11.7% year over year. Managerial financial margin advanced 1.2% sequentially and 13.0% year over year to R$13.5 billion ($6.9 billion). Net interest margin with clients fell 30 basis points sequentially and 70 bps year over year to10.9% in the reported quarter, mainly due to the decrease in the SELIC rate.

Banking Service Fees and Income from Banking Charges moved up 1.5% sequentially and 8.7% year over year to R$5.1 billion ($2.6 billion). Revenue from insurance, pension plans and capitalization operations grew 0.3% sequentially and 14.6% year over year to R$1.5 billion ($0.7 billion).

Itau Unibanco’s non-interest expenses were R$8.4 billion ($4.3 billion) in the reported quarter, up 3.2% sequentially and 5.5% year over year. Notably, the company experienced a 6.7% increase in administrative expenses while personnel expenses grew 1.3%.

The rise in administrative expenses stemmed from seasonal factors and elevated marketing expenses in the quarter, in addition to the standardization of accounting criteria for depreciation between group companies. Moreover, increase in expenses with employee terminations and labor claims primarily related to the impacts of the restructuring process carried out at the company contributed to the uptick in personnel costs.

In the second quarter, Itau Unibanco’s efficiency ratio reached 45.0%, reflecting an increase of 50 basis points from the prior quarter.

Provisions for loan losses at Itau Unibanco decreased 0.7% sequentially but moved up 17.3% year over year to R$6.0 billion ($3.1 billion). Elevated default levels of the vehicle, personal loan (primarily instalment payment plans and overdraft accounts) as well as small and middle market company portfolios contributed to this high level of provisions.

The nonperforming loan ratio (loan transactions more than 90 days overdue) reached 5.2% in the reported quarter, increasing 10 bps sequentially and 70 bps year over year. This marked the fifth consecutive quarter of increase in the nonperforming loan ratio.

Itau Unibanco’s credit portfolio, including endorsements and sureties, reached R$413.4 billion ($211.2 billion) on June 30, 2012, increasing 3.2% from the prior quarter and 14.8% year over year.

As of June 30, 2012, Itau Unibanco’s total assets amounted to R$888.8 billion ($454.2 billion), down 0.9% from the end of the prior quarter. However, total assets were up 12.0% from the comparable period in the prior year.

However, recurring return on average equity decreased to 19.4% in the reported quarter from 20.0% in the prior quarter and 20.4% in the year-ago quarter. The Bank for International Settlements (BIS) capital ratio was 16.9%, up 80 bps both sequentially and year over year.

Outlook 2012

Itau Unibanco lowered its credit portfolio growth expectations for 2012. It now anticipates its credit portfolio to grow 13–15% excluding vehicles. The company is lowering its credit portfolio and car financing from R$60 billion by the end of 2011 to R$50 million–R$52 billion in this segment. This compares with the prior expectations of credit portfolio growth of 14–17%.

Itau Unibanco currently projects a rise in provision expenses for loan losses in the remaining quarters of 2012. Loan loss provision expenses are expected to be R$ 6.0 billion–R$ 6.5 billion in the third quarter and R$ 5.7 billion–R$ 6.2 billion in the fourth quarter.

Itau Unibanco expects an increase in banking service fees and result from insurance, pension plan and capitalization operations to be 10– 12%. Non-interest expense is likely to grow in the range of 3.5–6.5%, compared to the prior expectation of 4–8% rise. The company, however, maintained its prior expectation of a 200–300 basis point improvement in the efficiency ratio.

Recent Development

In July, in an effort to boost its payroll debit loans business, Itau Unibanco Holding SA, through its subsidiary, Itau Unibanco S.A. entered into a joint venture (JV) agreement with Banco BMG S.A. The JV will be called Banco Itau BMG Consignado S.A. and will offer payroll deductible loans across the country.

Itau Unibanco will have a 70% controlling stake in this JV while BMG will hold the remaining 30%. The majority of members of the Board of the JV would be appointed by Itau. The JV will commence its business with an initial capital stock of R$1 billion ($492 million).

Moreover, the agreement terms entails Itau Unibanco to offer up to R$300 million per month as funding for BMG's Payroll Debit Loan operation for a term of five years.

Itau Unibanco aspires to be a leader in the payroll loans industry and expects its JV to originate a total payroll loan portfolio of R$12 billion in the next two years. The deal would also help the company in offering its banking products to approximately 3 million new customers.

In Conclusion

Itau Unibanco’s solid business model, this strategic JV, a diversified product mix, growing service fees, cost control and expanded credit portfolio are encouraging. But we believe that besides asset quality concerns, increasing competition and the stressed conditions in the Brazilian economy pose risks.

Moreover, we believe that for Itau Unibanco, which is experiencing a rise in default rates on its loans, the move to boost the low risk payroll deductible loans business is a strategic fit. Notably, payroll deductible loans refer to loans which 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 authoritative power to deduct the monthly installments directly from the payroll account. Hence, the risk is low with such loans and chances of default reduce meaningfully.

Itau Unibanco’s shares retain a Zacks #3 Rank, which translates into a short-term Hold recommendation. Its closest peer Banco De Chile (BCH - Free Report) also retains a Zacks #3 Rank.

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