Saturday, July 5, 2008

Taking Stock in BAP

I'd like to welcome all readers to The DIV-Net for our first post by an Associate Member of our community.

I've chosen today to profile a stock in my Taking Stock inTM series that I consider to be a small gem in my RSP and at first glance might not appear to match my investing style or approach. It's expensive, has built momentum over the last few years, is not well known and when compared to competitors within the region, such as Bank of Nova Scotia and Banco Bilbao Vizcaya Argentaria, doesn't strike a special confidence within a value or dividend growth investor.

My belief is that value, growth or dividends don't need to be separated from each other in order to achieve success when investing. Value is a relative term, dividend investing has many disciplines and any company that doesn't have tangible growth is likely to be a poor investment for the long-term. Price, while important, is not the absolute determinant for investing in a great company and BAP is an example of this. During a brief selloff in February I bit the bullet and made a purchase that I feel will be an integral component to the global diversification of my RSP.

In an environment of financial chaos, lack of transparency and global credit uncertainty many value investors have avoided or been hurt by domestic and global financial stocks as they precipitously fell from what we now know were exaggerated valuations. Many dividend investors have also succumbed to attractively high yielding investments only to see the value of their shares plummet as dividends are cut, losses mount and the full extent of the credit markets appeared.

My style and discipline at times is a hybrid and leads me to examine sectors with a different perspective as I dig deep for a new perspective. Credicorp impressed me not from its valuation, its dividend growth or its market location, but from its underlying fundamentals of impressive strength. When I look to past generators of growth and innovation in various industries around the world what is immediately clear is that this company understands the needs of its target market, how to best penetrate existing barriers and tailor product offerings to best reach its customers and improve its profitability.

I first came across BAP when I was conducting a competitive analysis in early 2007 on BNS and the stock later led me to BBV during this same activity. At first glance I perceived this financial services holding company as very expensive in comparison to its regional peers, to larger global financials and stuck in a geographical area that didn't appear to offer much growth. Sometimes as an investor you have to exhibit more patience than you feel is needed and maintain an open mind. As a value investor you might spend hours sifting through information for a chance that you'll discover some sort of a value stimulus, the stock still turns out to be a dud and you can carry on in your efforts.

Every investor has their process and mine is dominated by a situational analysis. When many investors look exclusively to quantitative data I look at the rest of the story to form my opinion of an investment. After completing a SA on BAP and continuing to dig deeper I found that their strategic focus held an innovative tool that as an investor was rare and something I wanted to be a part of.

Background:

BAP is an ADR for a company that operates primarily within Peru & Bolivia and is surrounded by regional goliaths Brasil and Chile. Peru in 2007 had an annual GDP of approximately $109B US giving it a per capita income of approximately $4600 compared to $6800 for Brasil. While many investors are concentrated through their BRIC investments on Brasil and Mexico, other smaller regional economies offer cheaper valuations with equal fundamentals in unknown and overlooked companies. Noted is the recent acquisitions made by BNS in Peru, Chile and BBV in Latin America that help to demonstrate this point. The financial infrastructure of this region is largely fragmented with many competitors struggling to reach a large rural population in varying geographies that has continues to provide difficulties for operating banks. To solve this issue BAP has been a company of innovation that's fuelled growth in both its product offerings and how it reaches customers away from the traditional North American/European framework of banking. It's my belief that many investors have been overlooking the key growth engine for this company just as I did initially at first glance. More on this soon.

First let's look at BAP's structure:

Credicorp operates as a holding company of financial subsidiaries that include Banco de Credito del Peru (BCP), Banco de Credito de Bolivia (BCB), Atlantic Security Holding Corp, Pacifico Peruano Suiza (PPS) and Prima AFP. Together they employ over 16,000 and conduct a variety of activities that includes insurance, personal/commercial banking, wealth management and operation of a large regional pension fund. The banking component of the business is run through BCP, and its smaller partner BCB, ASHC operates the wealth management business, PPS operates the insurance division and Prima AFP is their pension fund management company.

Infrastructure:

In 2007 BCP spent $70M on infrastructure by opening 36 new branches, 93 ATM's and 670 Agentes units. In 2008 they have budgeted $150M in spending (over double) with the intention to open an additional 75 branches, 150 ATM's and 350 new Agentes BCP's. Included in this budget is continued spending on business equipment, business software applications and two computer centres currently under construction. Since 2005 their number of ATM's has grown by 36%, branches by 25% and Agentes by 1900%.

Value Stimulus:

Agentes BCP (or Agent BCP in English) is a network of individual low-cost, high volume transaction centres that allow customers to pay bills (telephone, utilities, credit cards, school tuition), make cash deposits or withdrawals and do miscellaneous banking without the need for travelling to traditional branches for routine needs. These booths often have a single employee, are located in markets, residential or commercial zones that benefit rural and high-density populated areas where infrastructure may not be available for extensive branch development. While to a North American investor these might first appear to be make-shift cardboard box deployment of services, the technology implanted is industry standard and it serves a very real need in developing economies where individuals may not have the time, money or transportation available to do their banking safely or often. When you examine the rise of personal banking deposits in the past few years for the company the net effect to profitability of this innovative service offering is crystal clear. Instead of needing to travel long distance customers can walk to a number of locations close to their home or businesses with minimal effort. The company now has an opportunity to reach a higher number of new or existing customers and these clients have an opportunity to use banking services more frequently. The end result is a higher number of deposits, increased transactions and higher overall usage that at pennies per event generates a high level of fees for the company.

Note that the Peruvian economy grew at 9% in 2007 (highest since 1994) and was fuelled by construction, manufacturing and regional/international commerce. Trade and regional development increased significantly through various projects such LNG projects (Camisea), mining (Las Bambas & La Granja) and infrastructure projects of local governments. While exports declined in real terms due to increased regional competition, inflation was moderate at 3.9% which was well below the LA average. Lower tariffs on international trade and recent free trade agreements for the country and region continue to help the economic zone to mature and real incomes to increase with inflation forecasted to decline slightly to 3.8% in 2008. In April of this year a key event occurred when FitchRatings raised Peru's government debt rating to investment grade that further opens the market for a higher level of foreign investment.

Operations:

The banking division of the company, BCP, has been in existence 1882 and takes pride in its conservative roots when it changed its named from Italian Bank to BCP in 1942. The bank has been largely unaffected by recent global turmoil over the past twelve months as total assets and deposits continue to conservatively outpace its' total loans. The bank operates in a conservative environment and possesses adequate margins of safety that place its depository obligations well above loan amounts. Their loan quality (past due loans over total) declined to 1.9% in 2005, 1.3% in 2006 and 0.7% in 2007 from a high of 8.5% in 2001. This decrease largely has been in part to high quality corporate business loans that have continued to compose more than 60% of total loans outstanding backed by higher levels of tangible assets and operating income. It is noted that historically the Peruvian banking market has held lower past due loan rates on average than larger markets in Brasil and Columbia with BCP's loan quality continually being below industry averages for banks in the region during the past ten years. ROA has increased steadily from 1.0% in 2004 to 2.3% in 2007 and BCP, as of Q1'08, had 32% market share of loans with 37% derived from retail. YoY transaction growth from their retail segment was up 20.6% with internet use up 31% and Agentes usage up 310%. BCB, their Bolivian bank formerly known as the People's Bank of Bolivia, has continued to enjoy a mirror of effects as BCP continues to innovate, implement new product offerings and focus on infrastructure to drive successful growth in BCB's markets. While Spanish might not be your first language, a quick look at the BCP website demonstrates a clear focus on their mission, vision, values and adherence to ethical principles.

As an investor who concentrates on strong and clear strategic management, BAP's corporate strategies and execution have continued to impress me. The single clear goal among its units is to become a leader in each segment of operation and sustain current activity and market share. The company's focus remains to grow the business of BCP through improved product offerings, expanded retail banking, distribution channels & network expansion while maintaining a conservative approach to risk. Their insurance business continues to restructure in order to expand into personal insurance through differentiation, product offerings and service with an additional focus on a partnership with AIG. Prima AFP, their pension fund, intends to increase its fee structure, generate higher profits from fund management, increase volume of funds and search for synergies with other BAP subsidiaries. Their asset management division, ASHC, continues to look for opportunities to grow through integration within each business segment.

Quantitative:

Q1 results for 2008 came in with EPS of $2.23 which comprises 51% of their full 2007 EPS. Past due loans did rise 0.1% to 0.8% with loan growth YoY for corporate at 35%, retail at 81% and foreign currency corporate loans at 60%. Total assets grew by 52% and BCP reported that Agentes locations increased 11% to a total of 1358. Overall expenses declined 8.9%, fee commissions from retail banking increased 27.7% YoY and wealth management volume in mutual funds rose to 43.7% of total market share which is currently double their closest competitor (BBV). They continue to be a leader in market share both in loans & deposits.

Five and ten year profit growth for BAP stand at 54.5% and 29.0% respectively after growing from $20.3M in 2000 to $351M in 2007. Currently the company's dividend sits at $1.50 per share providing a yield under 2%. While this might exclude the company for consideration by investors who seek yield the five year growth rate of the dividend sits at a very healthy 23.7%. The company has recently stated that they are focused on financing growth by using 60% of operating earnings versus raising further capital or using expensive debt facilities. The current payout of 34.1% leaves ample room for continued growth of the dividend as the business grows profits at their current pace. Return on equity for 2007 was 22.9% and stands at a very respectable seven year average of 13.3%.

Threats:

Investors shouldn't perceive the strong growth of BAP due to a lack of serious competition in their operations. In Peru BCP competes directly with operations of three large international banks (BNS, BBV and InterBank) and a few smaller competitors (Interfondos, Del Trabajo, Mi Banco & Falabella).

The earthquake in southern Peru in August of 2007 also impacted their insurance business when claims rose to $103M. Premiums did grow 25.4% to $467M to help compensate for those unexpected losses, but this has put into question the stability of the region for potential future losses. RIMAC, a fellow insurance competitor, has demonstrated an ability to be quite competitive in PPS's market and is noted as a serious competitor to further growth in market share as each has similar products and established networks in the market.

One impressive observation I did make during my initial analysis was that the company's financial statements are audited by Ernest & Young. This in my opinion adds an additional level of transparency to a company that operates in an environment where investors often express hesitation due to historical failures of financials in the region.

Putting it all together:

I mentioned earlier that BAP was an unusual investment for a value investor such as myself for a number of reasons. While it fits my criteria for enduring value in my RSP, when I bought the stock I paid a very rich P/B of ~3.5 times which is much higher than most other global or regional banks in this environment. But as I examined the company's fundamentals, organic growth and ability to create innovative product offerings that are well adopted by their target market I felt that a traditional valuation for a bank made little sense. While P/B has swelled in recent years their book value growth has averaged an impressive 12.4% and the company's returns to investors has consistently been over 25% per annum. The company also reports its earnings in USD, but its assets are purchased and utilized in a different currency. Their underlying infrastructure assets need to be put into proper context since BCP's operations, existing infrastructure and development are based upon simple, mobile and low-cost operations and company owns very little real estate. This inflates their P/B on a relative basis and makes them appear expensive in comparison to earnings or other global financial institutions with substantial RE assets.

In conclusion BAP offers a distinctly different investment for a long-term investor. They are well positioned to benefit from long-term growth in Latin America, have adequate earnings, abundant cashflow to fuel growth organically or through acquisition and have a stable foundation of operations in their banking divisions to expand the financial services of their subsidiary divisions.
The high valuation in respect to its peers is clearly a deterrent for an investor initially, but the company offers excellent opportunities when you examine their operations.

For disclosure purposes I hold a relatively small position in BAP when compared to the number of shares I own in BNS and BBV which are both more global organizations. While growth should continue for BAP in the region there is an obvious need to expand into new markets to help balance out regional risk and I expect management to continue operating on a growth platform while integrating their supplementary businesses.

This article was written by Nurseb911 at TMWTFS. You may email questions or comments to me at nurseb911 [AT] gmail [DOT] com.

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