Financials non-banks. abc. Non-bank Financials team. Paulo E Ribeiro Analyst HSBC Securities (USA) Inc paulo.e.ribeiro@us.hsbc.

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1 Financials non-banks Non-bank Financials team Paulo E Ribeiro Analyst HSBC Securities (USA) Inc paulo.e.ribeiro@us.hsbc.com 1

2 2 Sector structure Redecard Cielo Card merchant acquirers Non-bank Financials Capital markets enablers Brasil Insurance Insurance brokerage Latin America Equity Research Listed stock exchanges BM&F Bovespa Bolsa Mexicana de Valores Cetip Fixed income and derivates registrar Source: HSBC

3 Jun-12 May-12 Apr-12 Sector PE (12m forward) history Jun-11 Jul-11 Aug-11 Sep-11 Oct-11 Nov-11 Dec-11 Jan-12 Feb-12 Mar-12 Source: HSBC, Bloomberg (as of price close of 28 June 2012) BVMF3 CIEL3 RDCD3 CTIP3 BRIN3 BOLSAA 3

4 Sector description The non-bank financial sector in Latin America can generally be classified as intermediaries or infrastructure providers for the financial industry. It includes businesses such as card merchant acquirers, capital markets enablers and insurance brokers. Paulo Ribeiro Analyst HSBC Securities (USA) Card merchant acquirers: The payment industry in Brazil includes plastic card manufacturers (such as Valid) to merchant acquirers (Redecard and Cielo, which account for 95% of the transactional volume). Acquirers are central to the industry, as they sign up merchants for card acceptance and provide the terminals for capturing card payments. They also work behind the scenes to provide authorization, data transmission, and settlement functions for electronic payments. In Brazil, acquirers generate revenues by charging a percentage of the value of each credit and debit card transaction that goes through their network as well as a monthly fee for the rental of capturing terminals (called POS) and for advancing the payment of credit card receivables to merchants. Revenues are directly linked to card transaction volumes and to card usage in Brazil. All listed players in this segment are in Brazil. In the broad card payment space in Latin America, other listed companies include CSU CardSystem, the largest independent processor of card payments in Brazil, and Valid, the largest provider of technological solutions for the payment industry in Brazil. Capital markets enablers: This segment provides the infrastructure that enables the functioning of capital markets, from trading to custody and risk-management, from equity to over-the-counter (OTC) derivatives. The sector can be divided into two sub-sectors: listed stock exchanges (such as BM&F Bovespa and Bolsa Mexicana de Valores) and fixed income and derivatives registrars and custodians (such as Cetip). Both sectors are characterized by monopolistic structures: BM&V Bovespa and Bolsa Mexicana de Valores are the only exchanges for equities and exchange-traded derivatives in Brazil and Mexico, respectively. Cetip is the only registrar and custodian for fixed income and it holds 75% of the registration of OTC derivatives in Brazil. BM&F Bovespa is one the largest exchanges in the world in terms of market value, and the leading exchange in Latin America. As a vertically integrated exchange, BM&F Bovespa supports trading as well as pre- and post-trading services for a broad range of products, such as equities and derivatives contracts. Bolsa Mexicana de Valores (BMV) is the one-stop shop for all capital markets infrastructure in Mexico. BMV has a vertically integrated and diversified business model, providing a wide range of services (and thus capturing the full revenue stream) spanning the lifecycles of a diverse set of financial instruments. In terms of product offerings, BMV is a mix between BM&F Bovespa (equities and exchange-traded derivatives trading and clearing plus data sales) with Cetip (custody and registration/maintenance services for fixed income and derivatives). Cetip is Latin America s largest registration agency, custodian and depositary, and settlement platform primarily in fixed income, such as interbank deposits, time deposits, and corporate bonds; and OTC derivatives. Following its acquisition of GRV Solutions S.A. (GRV) in December 2010, it also became the largest registrar of car loans in Brazil and the only one with an integrated electronic platform. In Latin America, the only other listed capital markets enabler is the Colombian stock exchange, Bolsa de Valores de Colombia. Another public-traded company whose drivers are capital markets related is BTG Pactual. It is an investment bank and asset and wealth manager with a strong franchise in Brazil and a growing presence throughout Latin America. 4

5 Insurance brokerage: Brokers are the main channel for sales and distribution of insurance products in Brazil. Brazil is the largest insurance market in Latin America, with premiums of BRL185.1bn (including contributions to investment-type products such as VGBL and PGBL (supplemental retirement investment accounts) in 2011, growing at around 14% CAGR from 2007 through In 2011, insurance penetration, measured in terms of net premiums as a percentage of GDP, stood at 3.7%, indicating room for growth. Brasil Insurance s (BRIN) strategy is to be a first mover in acquiring and consolidating brokers in the highly fragmented market for insurance brokers in Brazil. Through its 43 brokerage companies, BRIN sells a broad range of insurance products, including health, auto, and high risk insurance, among others. We believe that BRIN, one of the largest players in this market together with AON and Marsh McLennan in the US, has a 1.5% market share (based on premiums underwritten) and it could get to about 5% by 2014, via organic growth and acquisitions. A substantial part of the proceeds from the IPO, together with high rates of cash generation, are used to fund acquisitions. In the overall insurance market, there are other listed companies in Brazil such as insurers SulAmerica and Porto Seguro and affinity groups operator Qualicorp. In Mexico there is only one listed insurer, Qualitas. Key themes Competition. The overarching theme for diversified financial names in Brazil is new entrants and competition. This has been a trend since early 2011 when the announcement by a US exchange, BATS, that it planned an alternative exchange drove BVMF shares down and concerns over price erosion for Redecard and Cielo weighed on those stocks. Adding to uncertainty, and reduced visibility, in the medium term for these names is a pending tender offer for Redecard by Itaú Unibanco (for Redecard and Cielo) and the release in June in 2012 of a study commissioned by local securities regulator, CVM, about the cost of trading and post-trading services for equities in Brazil and the (lack of) equity trading alternatives (for BVMF). For Cetip, the deepening of the financial markets and substantial investment needs in Brazil are the main drivers to focus on but there is a looming risk of competition from BVMF in OTC markets. For Brasil Insurance, after a full year of track record under its belt since its IPO in November 2010, the focus will continue to be on the company s ability to deliver on accretive acquisitions with revenue growth and efficiency gains. For the Bolsa Mexicana, the prospects of competition are extremely limited given the relatively small size of the Mexican market and its relationship with the lead local brokers (which own collectively 40.5% of Bolsa s shares). Technology and new products. Technology upgrades are also a central theme for As competition heats up, companies in the diversified financials space are investing in more robust platforms and new products with an eye on better operational controls and revenue synergies. Both Bolsa and BVMF will launch new trading modules for equities with increased throughput and reduced latency (time for execution of trading order). BVMF is also integrating clearing systems. The acquirers are focusing on lowering cost per transaction and expanding product offering (such as for small transactions and contactless payments). Cetip continues to develop its corporate fixed income trading platform, its collateral management business and a mortgage-registration product. Brasil Insurance is improving monitoring and integration of its increasing broker-base and developing better quote screens for insurance products. 5

6 RDCD3, CIEL3: 2012e PE comparison with peers based on consensus estimates for the acquirers PAYX US V US ADP US HPY US MA US TSS CIEL3-con CIEL3- HSBC Est RDCD3-con RDCD3- HSBC Est GPN US WU Source: HSBC, Thomson Reuters Datastream Operating leverage and volume growth. The story for the diversified financials be it acquirers, capital market enablers or insurance brokerage is one of volume growth and operating leverage. The name of the game is scale, with prices falling as volumes increase and dilution of costs over a larger base allowing for relatively high EBITDA margins. High cash generation and dividend payout. Another characteristic of this sector is the relatively high dividend payout. These companies are strong cash generators with low capex requirements allowing for high payout ratios. Cetip has limitations of a 50% payout ratio in 2012 due to debenture covenants. BRIN should maintain in 2012 a payout of 80%, similar to Payout has been, typically, 90% for Redecard, 80% for BVMF and 70% for Cielo. Sector drivers Some of the sector drivers are consistent across the different sub-sectors but others are specific as discussed below. Increase in discretionary income: From a consumer perspective, the oil that greases the wheels of this sector is the rise in discretionary income, which fuels investment in financial instruments, growth in credit and purchase of insurance products. Increases in disposable income per capita have traditionally been linked to increases in consumption of discretionary items such as extended guarantee for durable goods, insurance for the vehicles, savings allocated to investments and credit card usage, for instance. Card usage: Credit and debit card transaction volumes have been resilient to fluctuations to GDP, credit growth interest rate, nonperforming loans, retail sales or even private consumption patterns over the last 10 years. Payment card volume growth (in BRL charged) has been growing at 20%+ for the past 10 years driven by both increased purchasing power in Brazil but more importantly (and more consistently) from the migration of paper (cash and checks) to plastic (cards). That is, card usage has been increasing its share of private consumption consistently for the past 10 years. 6

7 CTIP3: Brazil has room to grow in debt issuance: Debt outstanding as a percentage of GDP, September 2010 CTIP3, BVMF3: Notional values of OTC and exchange-traded derivatives outstanding as number of times GDP, Sept % 40% 30% 20% 10% 0% Developed Markets Avg 18 % Developing Emerging Markets Avg 8% 1.6 % Turkey Brazil Australia Mexico South Africa UK Japan US Spain x 9.8x 2.1x 2.3x 1.3x 0.2x ETD OTC Total Brazil World Fund, Bank for International Settlements (excludes debenture issues by financial institutions) Source: Cetip, Oliver Wyman, McKinsey, Brazilian central bank, International Monetary Fund Source: BIS, Cetip, BM&F Bovespa, HSBC Financial sophistication: From a corporate perspective, the development and increased sophistication of local capital markets with a broader and more complex range of financial products is linked to increased trading and custody volumes, as well as to the opening of new sources of revenues for capital markets enablers. Equity transactions at BVMF and Bolsa and insurance premiums are more susceptible to deceleration in the overall economy and concerns over global scenario (shares of stock exchanges are leveraged plays on sentiment towards stock markets). The expectation of lower real rates in Brazil for the coming years (following cuts in the benchmark Selic rate in 2012) could drive increased investor interest in equities and corporate fixed income instruments (in search of a better yield for their portfolios) and could drive use of capital markets as an attractive source for funding. Average trading volumes for BVMF have increased, on average, 25% since 2004 (11% from 2009 to 1Q12) and for the Bolsa the growth has been 15% on average between 2008 and The Bolsa also benefits from increase utilization of fixed income instruments as a means of financing for corporate investment. For Cetip, growth in the registration and custody services from fixed income and OTC derivatives has been fairly steady over the years, but the GRV acquisition in December 2010 added exposure to the more cyclical consumer business. BVMF3, BOLSAA: Market capitalization/gdp for both Brazil and Mexico significantly lags behind most of its emerging market peers 168% 170% 166% 138% 137% 130% 129% 126% 118% 107% 107% 100% 95% 100% 93% 78% 82% 85% 81% 75% 70% 73% 67% 75% 67% 75% 74% 62% 66% 53% 53% 53% 44% 36% 39% 21% Chile Singapore UK Canada USA Korea India China France Japan Brazil Mex ico Source: BM&F Bovespa, World Bank, HSBC, WFE, HSBC 7

8 Technological upgrades: Improvements in technology are critical to the financial non-banks sector to support volume growth of more standardized products and to provide flexibility for development of more customized ones. In essence, the companies in this sector are electronic intermediaries that facilitate transactions between counterparties. Deficiencies in technological offerings could provide an opening for competitors thus explaining the typically robust capex of those companies. The companies in our coverage recognize the need to provide superior service and products to clients by adapting to an ever changing technological landscape. BVMF, for instance, expects to spend over BRL1bn in capex from 2019 to 2013 in new trading (in association with US exchange CME s post-trading systems. Redecard and Cielo are among the largest buyers of POS (point-of-sale) terminals in the world and have one of the most up-to-date bases of POS in the world. Bolsa is developing a new matching engine for equities and derivatives with lower latency (faster order completion) and greater throughput (capacity to handle order from investors). Cetip recently developed a collateral management platform with Clearstream (part of Deutsche Bourse) and is working on a system for trading of corporate fixed income instruments together with Intercontinental Exchange (ICE US). Brasil Insurance is implementing on managerial systems that allows it to deliver insurance quotes and control expenses to its 40+ different brokers in a consistent and efficient way. Regulatory framework: This sector is highly sensitive to changes in regulatory framework. From trading rules for exchanges to taxation of financial instruments, from oligopolistic/monopolistic structures to obligation to sell insurance via brokers, significant changes in regulatory rules can (and have already) produced profound impact (for better or for worse) on the earnings visibility and growth capacity of the companies in the sector. For card merchant acquirers, regulators promoted an increase in competition between the two large players, Redecard and Cielo, in mid-2010 by pushing for an end to the exclusivity agreement between Cielo and Visa and between Redecard and MasterCard in Brazil. For BVMF, regulators are conducting a review of the costs and benefits in terms of trading and post-trading services in equity markets from allowing the entry of a competing platform. In Mexico, the regulatory framework has been generally favorable to Bolsa by making more flexible trading rules and order types and investment regimes by local pension funds. In terms of the OTC market, we expect regulatory changes in Mexico and in Brazil, in line with international proposals by the G20, to increase transparency of the OTC derivatives market. This should be a positive for both Bolsa and Cetip, and to smaller extent, BRIN3: Insurance potential high in auto and homeowner segments BRIN3: Population migration towards upper classes has boosted consumption 57.8% 92.0% 11% 12% 12% 13% 14% 15% 15% 17% 17% 42% 44% 46% 48% 50% 52% 53% 55% 56% 42.2% Auto 8.0% Homeow ners 47% 44% 42% 38% 36% 32% 32% 29% 27% * Pentrated Unpenetrated Class DE Class C Class AB Source: Sindipeças, Fenseg, IBGE, HSBC Source: Porto Seguro, FGV, HSBC 8

9 BRIN3: Insurance penetration (as % of GDP) 14.0% 12.4% 12.0% 10.0% 8.0% 6.0% 4.0% 2.0% 1.9% 2.3% 3.4% 3.8% 4.0% 5.1% 5.4% 7.2% 7.3% 8.1% 8.0% 9.5% 10.1% 10.3% 0.0% Mexico Russia Brazil China Chile India Spain Germany Canada Italy USA Portugal Japan France UK Source: Porto Seguro, Swiss Re, Sigma, HSBC BVMF. For Brasil Insurance, it is important to note that insurance brokerage is and should remain the main distribution channel for insurance in Brazil. By law, all insurance policies sold in Brazil must be sold through a registered insurance broker or sold directly by insurance companies, under certain restrictions. Valuation Investors consider different metrics when valuing financial non-bank firms, including earning multiples, cash flow multiples and dividend yield. The firms in the sector are strong cash generators and have operating leverage. We use an eight-year discounted cash flow, with a terminal growth rate of 4-5% and a cost of equity appropriate for each stock. Multiple comparisons for the financials non-banks are, at best, a very imperfect exercise as there are only one or two companies in each subsector. BM&F Bovespa and Bolsa Mexicana de Valores, and to a certain extent Cetip, are typically compared to global exchanges. It is important to pay attention to significant variations in the structure and earnings drivers between the exchanges. For instance, derivatives exchanges trade at higher multiples than stock exchanges, vertically integrated exchanges also typically trade at a premium to ones without post-trading services. For Brasil Insurance, the relevant comparison is the premium to which insurance brokers in the US mainly trade in relation to insurance underwriters and to compare that to the premium/discount that BRIN has in relation to insurers listed in Brazil, SulAmerica and Porto Seguro. For Cielo and Redecard, comparisons to international firms such as Global Payments or even to Visa and MasterCard are not relevant, in our view. 9

10 Sector snapshot Key sector stats Financials 21.28% of MSCI EM Latam Trading data ADTV (5 Year) (USD mn) Free float market cap (USD bn) Performance since 1 Jul 2002* Absolute % Relative to MSCI EM Latam 40.28% 3 largest stocks ITUB4.SA, BBDC4.SA, ITSA4.SA Correlations (5-year) with MSCI EM Latam 0.93 *Performance includes dividends Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012 Core industry driver (CTIP3): Credit growth May-05 Nov-05 May-06 Nov-06 May-07 Nov-07 May-08 Nov-08 May-09 Nov-09 May-10 Nov-10 May-11 Nov-11 May-12 Indiv iduals Corporates Total lending Source: HSBC, BCB Data, *June 2000 =100 Top 10 stocks Stock rank Stocks Index weight 1 ITAU UNIBANCO PN 4.33% 2 BRADESCO PN 3.86% 3 ITAUSA PN 1.47% 4 BMF BOVESPA ON 1.29% 5 GFNORTE 'O' 1.26% 6 CREDICORP 1.14% 7 SANTANDER BR UNT 0.78% 8 BANCO BRASIL ON 0.75% 9 PFBCOLOM PF. 0.68% 10 BSANTANDER 0.66% Core industry driver: GDP (BVMF3) and retail sales (RDCD3, CIEL3 ) growth * 20.0% 15.0% 10.0% 5.0% 0.0% -5.0% -10.0% -15.0% Q3-07 Q1-08 Q3-08 Q1-09 Q3-09 Q1-10 Q3-10 Q1-11 Q3-11 Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012 Country breakdown Country Weights (%) COLOMBIA PERU BRAZIL CHILE MEXICO 8.87 Source: HSBC, Thomson Reuters Datastream, MSCI, I/B/E/S, At June 30, 2012 Core industry driver: Insurance penetration levels versus developed countries (BRIN3) in Brazil is low 12.4% 10.3% 10.1% 9.5% 8.1% 7.2% 8.0% 7.3% 5.4% 5.1% 3.8% 4.0% 3.4% 1.9% 2.3% Mexico Russia Brazil China Chile India Spain Germany Canada Italy USA Portugal Japan France UK Q % Real GDP growth (annualized) Source: Thomson Reuters Datastream, MSCI *Annualized basis Core industry driver: Equities ADTV growth,* % ( BVMF3, BOLSAA) 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% -10.0% -20.0% -30.0% -40.0% Feb-11 Apr-11 Jun-11 *m/m growth Source: Company data, HSBC Aug-11 BVMF3 Oct-11 BOLSAA Retail sales grow th (annualized) Dec-11 Feb-12 Apr-12 Source: Porto Seguro, Swiss Re, Sigma, HSBC 10