DAVIVIENDA COVERAGE. All About Profitability and Growth. PFDAVVNDA - BUY - COP 31,300 per share May 8, Stock Data

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1 Apr-13 Jul-13 Oct-13 Jan-14 Apr-14 DAVIVIENDA COVERAGE PFDAVVNDA - BUY - COP 31,300 per share May 8, 2014 All About Profitability and Growth We are initiating coverage of Davivienda with a December 2014 target price (TP) of COP 31,300 per share (11.8% upside) and a BUY recommendation. There is still value, despite the 32% appreciation over the last 3 months. Davivienda has demonstrated its ability to improve profitability and market share from the recently acquired units in Central America (CA). When Davivienda acquired HSBC s operations in El Salvador, Costa Rica and Honduras ROAE was near to 4.5%, after 1 year of operations it reached 10.5% (16.2% of consolidated net income), we expect it to rise to 13.9% by 2018 with a positive bias. Upsides in ROAE and growth depend on Davivienda s market share of deposits in CA to a large extent, which would lead to improving funding mix & cost and balance sheet leverage. This leads us to believe in management s ability to accomplish the main goals traced for the medium term: 1) Increasing profitability in Colombia and CA, 2) Gain market share both in Colombia and CA, and 3) Position the bank as a key player in the region s financial system. Besides, Davivienda has been very clear on how they plan to achieve them: 1) Technological innovations, a shift to alternate banking channels, cost controls, leveraged operations and synergies in CA will boost estimated efficiency and lead long-term ROAE to 17.4% (FY13 15%). Plus, recovery of NIM and a rising proportion of interest earning assets will increase consolidated ROAA to 1.8% and ROAE to 18.1% in Stock Data Ticker BVC PFDAVVNDA Closing price (COP) 28,000 Target price 2014 (COP) 31,300 Upside 11.79% # of shares (MM) Mkt. Cap. (COP MM) 12,437,999 COLCAP Index weight 2.69% 52-week range 21,180-28,300 Source: Bloomberg and SERFINCO S.A. estimations Financial Information and Multiples E 2015E ROAA 1.90% 1.66% 1.64% 1.79% 1.83% ROAE 15.1% 13.7% 14.9% 16.8% 17.62% P/BV* 2.1x 1.7x 1.7x 1.8x 1.6x P/E* 16.2x 13.3x 12.3x 11.5x 9.6x Yield* 1.68% 2.30% 1.18% 2.25% 2.62% *At period's closing price. Expected multiples with closing price of 5/8/14 Source: Bloomberg and SERFINCO S.A. estimations Davivienda vs. Colcap ) Innovative service models and products will enable increasing market share in countries with high potential. Colombian and CA markets are concentrated, where around 5 competitors make up for more than 50-60% of the system s assets. Davivienda s strategy is focused on improving service models to form long term relations and gain market share in key segments such as commercial and mortgages. Furthermore, Davivienda plans to remain aggressive in social housing (VIS) projects in Colombia (44% of the system s total disbursements in the LTM as of Feb-14) Pref. Davivienda Source: Bloomberg COLCAP Index 3) Replication of value added products will give Davivienda a competitive edge. The goal is to spur regional cross-selling and payments through Davivienda. The bank expects to reach 2.4 products per client (currently 1.2) in 4 years through better service models and innovative products, grounded on a regional banking platform to be launched in 2Q14. Additionally Daviplata -free mobile banking service- will be implemented in CA, which is a very attractive and growing region. In Davivienda s case a clear path and strategy go hand in hand with attractive valuations that offer an entry point for value and growth. 2014E s leading multiples are 11.47x P/E and 1.81x P/BV. All of the above support our BUY recommendation for Davivienda. Nicolas Noreña T. Financial Services Analyst nnt@serfinco.com.co (571) Ext Jose F. Restrepo, CFA Equity Strategist jr@serfinco.com.co (574)

2 Positive Catalysts Increasing share of deposits in Colombia and CA to improve ROAE. Possible equity issuance would be positive for liquidity and float. Possibility of further M&A activity. Daviplata is outlined as the most likely to win the second bidding process for Mas Familias en Accion disbursements. Further extensions of housing programs in Colombia. Faster than expected improvement in access would boost financial penetration. Table 1. Income Statement Negative Catalysts Relatively low expected capital adequacy level could limit the bank s ability to grow despite deterioration in asset quality. Political instability in Colombia, Panama, El Salvador and Costa Rica due to changes in Presidents and/or Parliaments. Headwinds from Fed s tapering affecting investment returns. Implementation of IFRS in 2015 will broaden information disclosure, however we have no certainty on the outcome. Table 2. Balance Sheet Graph 1. Loan Portfolio Composition Graph 2. Loan Growth by Country Table 3. Financial Ratios Table 4. Stock Data and Multiples 2

3 E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E All About Profitability and Growth We are initiating coverage of Davivienda with a December 2014 target price (TP) of COP 31,300 per share (11.8% upside) and a BUY recommendation. There is still value, despite the 32% appreciation over the last 3 months. Davivienda has demonstrated its ability to improve profitability and market share from the recently acquired operations in CA. When Davivienda acquired HSBC s operations in El Salvador, Costa Rica and Honduras ROAE was near to 4.5%, after 1 year of operations it reached 10.5% (16.2% of consolidated net income). Furthermore, market share over loans and deposits has increased an average of 30 bps and 18 bps respectively. Upsides in ROAE and growth depend to a large extent on Davivienda s market share of deposits mainly in El Salvador and Costa Rica, which would lead to improvements in funding mix & costs and balance sheet leverage. In that sense, we expect CA s ROAE to reach 13.9% by 2018 (with a positive bias), contributing with 17.7% of consolidated profits in 2018 and 22.8% in We consider our market share projections to be conservative given the history (see graphs below). Graph 3. Davivienda s Share of Deposits in CA (as of Feb-14) Graph 4. Davivienda s Share of Loans in CA (as of Feb-14) We base our TP and recommendation on the following: Source: Superintendences of Finance; Serfinco S.A. 1) Increasing profitability in Colombia and CA through efficiency guided strategies. Technological innovations, a shift to alternate banking channels, cost controls, leveraging operations and obtaining synergies in CA will lower administrative efficiency ratio to 3.3% (47% cost-income) and lead long-term ROAE to 17.4%. All of the above, plus a recovery of NIM in Colombia will increase ROAA to 1.8% and ROAE to 18.1% in Graph 5. Administrative Efficiency by Country and Consolidated Operating Leverage 6% 5% 4% 5.22% 5.45% 4.92% 4.92% 4.59% 4.40% 4.21% 4.29% 4.03% 4.14% 4.04% 3.83% 3.94% 3.84% 3.71% 3.74% 3.60% 3.53% 3.64% 3.47% 3.54% 3.41% 3.49% 3.34% 3.28% 3.25% % % 1.53% % 0.89% % 0.00 Central America Colombia Consolidated Operating Leverage (RHS) Source: Davivienda; Serfinco S.A. estimations 3

4 2) Innovative service models and products will enable larger share in markets with high growth potential. Colombian and CA markets are concentrated, where around 5 competitors make up for more than 50-60% of the system s assets. Davivienda s strategy is focused on improving service models to form long term relations and take market share from large traditional players in key segments such as commercial and mortgages, which are poised to be the fastest growing segments over the coming years (see links to this document). Furthermore, Davivienda is planning to remain aggressive in social housing (VIS) projects in Colombia (44% of the system s total disbursements in the LTM as of Feb-14). 3) Diversification of the loan portfolio will contribute to improve asset quality. The bank s focus out of consumer loans and into commercial, mortgages and housing leasing will contribute to improve loan portfolio diversification and quality; given that consumer loans are more sensitive to slowdowns in economic performance. We expect strong loan growth to compensate a slightly lower margin on loans from this mix. Graph 6. Loan Portfolio Composition and Estimated Asset Quality (90 days NPL) Source: Davivienda; Serfinco S.A. 4) Replication of added value products will give Davivienda a competitive edge in CA. The goal is to spur regional cross-selling and payments through Davivienda. The bank expects to reach 2.4 products per client (currently 1.2) in 4 years through the improvement of service models and the replication of innovative products, grounded on a regional online banking platform to be launched in 2Q14. Our model contemplates a 7% 5 year CAGR of fees in CA, which does not fully reflect management s expectations. Additionally Daviplata -free mobile banking service- will be implemented in CA to compete in what is taking shape as a very attractive and growing business. The idea is to reach the income pyramid s base and increase bancarization with services that include transfers, payments and purchases through basic mobile phones (no internet needed). This system complements mobile app, online banking, ATMs and POS to construct a complete payment ecosystem accessible to everyone. We think the software s competitive edge is its free for users. We base our positive expectations in this product from experiences in Colombia, where Davivienda manages 300,000 clients and monthly disbursements of US$62 million of the Government s subsidy program Mas Familias en Accion. This program contributes to fees because it generates revenues from transactions. Furthermore, it is a source of non-interest bearing deposits. Click for more information on technological innovations and financial inclusion. 4

5 Daviplata: In 2011 Davivienda launched Daviplata, one of the biggest payments system in Latin America. It started with 500,000 clients and as of December 2013 it had 1.9 million users with transactions amounting US$1,038 million. It can be used with the 4 major mobile service providers in Colombia, opening a pool of opportunities to reach the 10.9 million Colombian adults without a savings account (34.4% of adult population). Daviplata offers the following services: 1)For traditional users: Pre-paid airtime purchases, utility-bill payment, national and international remittances, withdrawals at ATMs or banking agents (5,300 nation-wide) and transfers. 2)For companies: Payroll payments (Colombia s Military Forces use Daviplata), cash collection and payments. 3)Roamler: App users (Roamlers) are paid through Daviplata to accomplish certain activities with their smartphones. The app uses Roamlers collective data as a market research tool and sells it to corporate clients. Graph 7. Daviplata s Evolution Positive Catalysts: Source: Davivienda; Serfinco S.A. Increasing share of deposits in Colombia and CA to improve ROAE. As noted previously, upsides in CA s ROAE and growth depend to a large extent on Davivienda s market share of deposits mainly in El Salvador and Costa Rica, which would lead to improvements in funding mix & costs and balance sheet leverage. Our valuation model estimates leverage will go from 7.73 in 2013 to a maximum of 8.23 in 2018 since growing the deposit base is a tough goal to accomplish, and we rather have a wait and see stance. However, we expect Colombia s balance sheet leverage to increase from 7.54 in 2013 to 9.36 in 2018 (levels prior to stock issuance in 2011). Possible equity issuance would be positive for liquidity and float. Low estimated capital adequacy ratios open the possibility of equity issuances, which would be positive for liquidity, despite of representing a dilution risk. We estimate Davivienda will have a relatively low average capital adequacy ratio of 11% (minimum 9%) over the next 3 years, pressured by strong loan (RWA) growth. We believe one of the most favorable options to increase ratios would be to seek a stock issuance. As a matter of fact, management has already hinted its intention to raise capital between 2015 and 2016 though an ADR, which would have a positive effect on liquidity and float. Timing would be adequate given that ROAE is expected to reach levels above 17% in those years; nonetheless, our model does not include an equity issuance. 5

6 Possibility of further M&A activity. Davivienda s possible equity issuance could allow further organic growth with heavy financing of infrastructure and housing, but it also opens the door for inorganic growth through M&A activity. In that sense, we believe a potential market could be Guatemala due to the country s macroeconomic perspectives and increasing competitiveness, a solid financial system and the evidence from peers acquisitions. Daviplata is outlined as the most likely to win the second bidding process for Mas Familias en Accion disbursements in Colombia. Daviplata s strength as a financial inclusion tool (free and easy to access) leads us to believe it is the most likely to win the second bidding round for this subsidy program. If Davivienda were to win it, the client base would be doubled and Daviplata could keep expanding its reach. It would also help to increase the non-interest bearing deposit base and contribute to making NIM more sensitive to rate hikes. Negative Catalysts: Political instability in Colombia, Panama, El Salvador, Honduras and Costa Rica due to changes in Presidents and/ or Parliaments. Recent elections in El Salvador (officialist party), Honduras (officialist party), Costa Rica (opposition party - founded in 2002 center-left) and Panama (opposition party - right wing), as well as upcoming elections in Colombia (May 25) might pose a political risk coming forward. Headwinds from Fed s tapering affecting investment returns. Last year s results were greatly impacted by negative returns on investments during 2Q13 (COP -196,978 million) that led to a 2.44% and 4.43% annualized ROAE and NIM. In response, Davivienda cut its investment portfolio duration to protect it from further volatility in fixed income markets. We expect moderate returns of investments in 2014 (1% over interest earning assets) and up until treasury s strategy is realigned towards a more aggressive stance. Implementation of IFRS in 2015 will broaden information disclosure, however we have no certainty on the outcome. Colombian companies will be obliged to implement IFRS as of January With preliminary information available it is possible banks will have to eliminate the Available for Sale category of fixed income securities and include securitized loans in their balance sheets. However, regulation has not been definitively passed and changes are still unclear. Bank s ability to grow could be limited to some extent due to low expected capital adequacy levels. In the following section we will explain several factors that support our investment thesis from a macro perspective. 6

7 What Can We Say About Colombia and Central America? Table 5. Key macro and demographic figures - Colombia and Central America Source: IMF, SECMCA, Central Banks; Serfinco S.A. CA has undergone an economic and social transformation over the past few years as a region. Goals aimed to strengthen integration have already been accomplished by consolidating intraregional trade, customs and migration controls, educational systems and negotiation processes for the joint acquisition of medications. We expect further advances as the region seeks to sign new political and commercial cooperation agreements, consolidate a regional electric grid with competitive prices and take the integration efforts to the everyday citizen. El Salvador: Infrastructure investments and improving welfare indicators. Investments in infrastructure projects for 2014 contemplate US$650 million in roads and highways, US$51.1 million will be used in transportation and US$41.6 million in housing projects. There is also a potential investment of US$490 million in airport renovation as a part of an 18 year plan (ends in 2032) to position Salvadorian airports above regional peers. Costa Rica: Potential catalyst in infrastructure improvements. Similar to Colombia, Costa Rica has a lagging infrastructure that limits the country s economic performance. Marcos Camacho, transportation expert from the IDB, stated Costa Rica would need US$10 billion to improve the quality of its infrastructure and match South American countries with better indicators. The newly elected president said he will make infrastructure one of his top priorities in order to restore Costa Rica s competitiveness. Some announced projects contemplate investments in logistics (US$450 million), road and highways (US$850 million), and education infrastructure (US$167 million). Honduras: Revamping the country s electric grid and ICT & transportation infrastructure. According to local press and unions the newly elected president has been doing a solid labor in his 100 days of governing, with advances in security, job creation, education and electric transformation. According to the Government, US$5,000 million will be invested to reactivate economic performance, funded through public debt and loans from development banks. Panama: Heavy investments on infrastructure, transportation and welfare improvement. The country will continue investing heavily on infrastructure, transportation, energy, healthcare and housing. In that sense, Panamanian Government announced public investments of over US$13.5 billion for the next three to five years in key projects such as: i) US$2.5 billion in infrastructure, ii) US$1.9 billion in transportation projects, iii) US$534 million in new hospitals, and iv) US$417 million in energy related investments. 7

8 Improving Economic Performance will Lead to Higher Key Rates and NIMs in Historically low key rate in Colombia (3.50%) will bounce 225 bps leading to higher NIMs. A bounce of Colombia s key rate will lead to improving NIMs on asset re-pricing sensitivity. Colombia s economy will perform increasingly better over the next 4 years on heavy public investments and a recovering international context. Inflation will bounce (+78 bps to 3.5%) and Central Bank s rate will pick up (+200 bps to 5.5%) through Dec -15 to control any imbalances that may arise. In that sense, Davivienda s balance sheet structure will favor asset re -pricing through a majority of loans pegged to variable rates (inflation -CPI or UVR and deposits rate -DTF-). Improvements in local economic performance and FED s policy normalization will lead to higher key rates in CA. Less expansive monetary policy in USA is expected to increase inflation and interest rates in El Salvador (ES) and Panama (PA). Inflation in dollarized economies is linked to inflation in USA, in that sense, expectations of rising prices and rates in USA influence rates in ES and PA. In fact, over the past months, loan rates in those countries have been stabilizing or even increasing. Furthermore, foreign currency loans will also re-price in Costa Rica (39% of total loan portfolio) and Honduras (26%). Graph 8. Interest Rates in ES (3-month average) Graph 9. Interest Rates in PA (3-month average) Source: BCR; Serfinco S.A. Source: Superbancos (Local Banks); Serfinco S.A. CA will benefit from improvements in USA economy due to its relevance as a trade partner and remittance source. CA is heavily reliant on USA s economic performance as a trade partner and remittance source. We believe an improving context in that country for upcoming years is positive for the region s trade perspectives, and therefore, its outlook. A shift to inflation targeting and lower target ranges might mean rather quick rate hikes to control rising inflation. Costa Rica adopted inflation targeting recently and lowered its target range a 100 bps to 4% ± 1 pp. Underlying inflation picked up by 154 bps to 3.63% between January and May. Costa Rica s Central Bank (BCCR) increased its key rate by a 100 bps in March and 50 bps in May to 5.25%; mainly explained by a 10% YTD depreciation of the local currency and rising inflation expectations. Honduras Central Bank has kept its key stable at 7% as inflation remains under control, prices of its main exports and imports are stable and international reserves persist at 3 months of imports, which they consider to be acceptable. However economic surveys show analysts expect the key rate to be 20 bps higher in December. Graph 10. CA s Exports by Destination Source: SIECA; Serfinco S.A. 8

9 Boosting Financial Inclusion: GPFI and Governmental Efforts What is financial inclusion? Financial inclusion is the delivery of financial services at affordable costs to sections of disadvantaged and lowincome segments of society. Access, usage and quality indicators allow the measurement of financial inclusion in each country. This topic has gained momentum because studies have proven it accelerates economic growth and employment, redresses income inequality and contributes to poverty reduction. High reaching financial systems allow for a more efficient distribution of capital at lower costs (lower intermediation margins with higher volumes), which along with financial education increase financial penetration (Loans / GDP). Global Partnership for Financial Inclusion (GPFI) - Alliance for Financial Inclusion (AFI) Maya Declaration In 2011, members of the Alliance for Financial Inclusion (AFI) designed the Maya Declaration: a measurable set of commitments to increase financial inclusion. To date, central banks and financial policymakers and regulators from 40 developing and emerging market countries have set targets to increase access to formal financial services for the world s 2.5 billion people unbanked. Many more AFI members, spanning 90 countries, are expected to make commitments soon. It is worth noting that all Central American countries and Colombia are members. Graph 11. AFI Mebers and Maya Signatory Countries Source: GPFI What are regional Governments doing in order to increase inclusion? CA countries have made some advances in innovative banking channels to increase financial inclusion. However, the creation of regulatory frameworks and implementation has been slow. We expect further advances in the development and consolidation of these systems over the coming years. Financial Access Indicators Graph 12. Branches per 100,000 Adults Graph 13. ATMs per 100,000 Adults Graph 14. Adults With Savings Accounts Ecuador Peru Brazil Guatemala Average Panama Costa Rica Honduras Chile Latin America & Caribbean Colombia Mexico Argentina Dominican Republic El Salvador Paraguay Bolivia Nicaragua Brazil Chile Costa Rica Panama Argentina Mexico Ecuador Average Colombia Peru Latin America & Caribbean Dominican Rep. Guatemala Bolivia El Salvador Honduras Paraguay Nicaragua Brazil Costa Rica Chile Latin America & Caribbean Dominican Rep. Ecuador Argentina Colombia Average Bolivia Mexico Panama Guatemala Haiti Paraguay Honduras Peru Nicaragua El Salvador 55.9% 50.4% 42.2% 39.3% 38.2% 36.7% 33.1% 30.4% 29.5% 28.0% 27.4% 24.9% 22.3% 22.0% 21.7% 20.5% 20.5% 14.2% 13.8% Source: 2012 GPFI Basic Set of Financial Inclusion Indicators; Serfinco S.A. Average refers to the selected countries in the graph. 9

10 Boosting Financial Inclusion: What is the Region s Potential? Opportunities: Colombia and CA still have great potential in terms of increasing financial access. CA and Colombia have high accessibility to financial services, but low access in terms of adult population with savings accounts. We believe there is a vast potential in terms of new clients. In this context, the implementation of inclusion focused strategies is vital to get on with the trend and generate significant growth in client bases. Challenges: As always, the challenges to increase access to financial services can be overcome with a mix of financial education by official and private entities and a banking system able to attract new people. And as we previously noted, advances are already being made throughout the region. Graph 15. Domestic Credit to Private Sector vs. GDP per capita Source: 2012 World Economic Forum (Financial Development Report); IMF; Serfinco S.A. Graph 16. Adult Population with Savings Accounts (%) vs. Accessibility to Financial Services Potential Source: 2012 World Economic Forum (Global Competitiveness Report); Serfinco S.A. The question: Is Davivienda going to be able to attract new clients and grow them into potential customers for liability products? 10

11 Alternate Banking Channels and Regional Platforms - Key to Efficiency Technological innovations and the promotion of usage are key to improving efficiency as they make banking less dependent on physical access and lower use of capital intensive channels. We expect innovative banking channels to gain relevance in Colombia and CA as they are progressively gaining track as an option to improve efficiency in a sustainable manner. They offer several advantages when compared to traditional channels, where we would like to point out the following: Fewer customer service representatives are needed, saving money and resources. Mobile device and online banking usage might help increase customer loyalty since they make content available anywhere and at any time. Young populations (digital natives) are more inclined to use technology and they are just entering the financial system as potential customers, enabling the construction of long-term relations with the bank. Furthermore, traditional banking models offered access almost solely through branches and ATMs, which are capital intensive due to the cost of expanding them to rural and isolated populations. However, technological transformation has enabled banking to reach people through their mobile phones, smartphones, PCs and Banking Agents (BA - retail or postal outlet contracted by a financial institution to process transactions). These are capital efficient investments since they require relatively low investments (compared to branches and ATMs). Besides, they can be easily replicated and we are confident of their positive perspective. Graph 17. Evolution of Banks Number of Branches and Banking Agents (BA) in Colombia 100% 80% 60% 4,419 4,487 4,518 4,921 5, % 6,000 5,398 5,000 80% 4,000 60% 33,419 45,000 50,000 40,000 30,000 40% 3,000 40% 2,000 19,410 20, % 20% 0% 9,698 20% 1,000 4,880 5, % 0% ,000 0 Nation-wide Branches Y/Y Growth Nation-wide BAs Y/Y Growth Graph 18. Distribution of Population by Age Group Source: Banca de las Oportunidades; Serfinco S.A. Demographics, Government policies and macro perspectives favor the expansion of mobile and online banking. Latin American countries have young populations (digital natives), a strong reduction of poverty and indigence, a rising middle income class, strong broadband internet growth and high mobile phone penetration, that combined, favor the adoption of new technologies. Source: ECLAC 2010; Serfinco S.A. Expansion of mobile phones and broadband internet has been very fast in Colombia and CA over the last 10 years. This is a result of Governmental efforts to reduce economic inequality and give equal technological access to large portions of the population. We believe programs will continue strengthening over the upcoming years as countries try to achieve the millennium development goals. 11

12 Graph 19. Mobile cellular subscriptions (per 100 people) Graph 20. Internet users (per 100 people) Source: 2012 Development Indicators - World Bank ; Serfinco S.A. Some Examples of Government Subsidy Programs as Tools for Financial Inclusion Colombian Government started the Familias en Accion program back in 2000 and modified it in 2011, changing its name to Mas Familias en Accion. This is a cash transfer program aimed to reduce poverty and income inequality through the formation of human capital and improving the lives of poor and vulnerable families. According to National Planning Department (DNP) estimates, the absence of this program would increase extreme poverty by 1.2 percentage points and Gini would be 50 bps higher. The program has a COP 2 trillion (US$1.1 billion) budget for 2014 and Government expects to reach 2.6 million families. In CA similar programs are starting to be implemented. A Government program was recently approved in El Salvador and granted to Tigo Money. Camara Salvadoreña de la Industria de la Construccion (CASALCO - Construction Union) signed an agreement with Tigo to promote payroll payments of more than 23,222 employees through Tigo Money. According to company figures there are already between 5,000 and 6,000 people receiving their salaries through the platform. The company has more than 420,000 clients, 1,400 nation-wide authorized points and monthly transactions of ~US$20 million. This mobile carrier launched its e-money platforms in 2011 and has presence in Guatemala, Honduras and El Salvador. SICA - Integrating Central America as a Region The Central American Integration System (SICA) is the institutional framework of regional integration in CA, created by Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and Panama. Last year, Belize and Dominican Republic joined as a full members. SICA has already accomplished the consolidation of intraregional trade, reduction of customs and migration controls, establishment of a regional perspective on security issues, harmonization of the educational systems and creation of an integrated negotiation process for the joint acquisition of medications, which has allowed the region to see substantial savings. Source: SICA 12

13 Tag Along with the Central American Integration - Regional Banking Platforms As CA develops towards an integrated region, banks will tag along with the creation and evolution of regional corporations, intra-regional remittances (from labor mobility), trade transactions, etc. We believe, the demographic, macro and technological trends are positive for Davivienda and enables the expansion of the bank as an important regional player. Furthermore, innovative products, increasingly better service models, rising customer satisfaction scores and customer-centric marketing strategies will contribute to position Davivienda as a seemingly local player (local management). After discussing this scenario with management we noted they trust this will be an important catalyst to expand cross-selling and increase the average number of products per client. We believe the shift to alternate channels and the creation of regional platforms are key to unlocking better efficiency ratios. This innovative business model cannot be compared with the traditional banking we are accustomed to. However, we rather have a conservative stance in our estimations and project better efficiency ratios, although not out of the ordinary if one takes into account peers efficiency ratios across the region. Table 6. Last Twelve Months Efficiency (Assets) Across CA Costa Rica El Salvador Month System Davivienda BAC Scotiabank Month System Davivienda BAC Agricola Jan % 3.60% 2.77% 3.63% Jan % 3.41% 3.17% 2.51% Feb % 3.58% 2.74% 3.66% Feb % 3.45% 3.14% 2.50% Mar % 3.56% 2.80% 3.67% Mar % 3.41% 3.16% 2.52% Apr % 3.67% 2.78% 3.69% Apr % 3.40% 3.19% 2.45% May % 3.68% 2.82% 3.69% May % 3.30% 3.16% 2.51% Jun % 3.77% 2.81% 3.69% Jun % 3.31% 3.10% 2.52% Jul % 3.76% 2.83% 3.73% Jul % 3.36% 3.12% 2.55% Aug % 3.76% 2.79% 3.69% Aug % 3.37% 3.07% 2.53% Sep % 3.87% 2.76% 3.74% Sep % 3.34% 3.08% 2.50% Oct % 3.86% 2.73% 3.68% Oct % 3.24% 3.07% 2.51% Nov % 3.76% 2.65% 3.64% Nov % 3.19% 3.06% 2.50% Dec % 3.74% 2.57% 3.63% Dec % 3.02% 3.03% 2.49% Jan % 3.74% 2.60% 3.63% Jan % 3.13% 2.96% 2.50% Feb % 3.59% 2.57% 3.46% Feb % 3.06% 2.86% 2.52% Mar % 3.78% 2.64% 3.42% Mar % 3.08% 2.87% 2.53% Y/Y -26 bps 21 bps -15 bps -24 bps Y/Y -12 bps -32 bps -29 bps 0 bps Honduras Panama Month System Davivienda Atlantida FICOHSA Month System Davivienda BAC* Banistmo** Jan % 5.77% 4.72% 4.63% Jan % 1.20% 1.69% 1.73% Feb % 5.80% 4.75% 4.62% Feb % 1.12% 1.67% 1.71% Mar % 5.91% 4.62% 4.52% Mar % 1.06% 1.65% 1.82% Apr % 5.78% 4.64% 4.54% Apr % 1.02% 1.63% 1.83% May % 5.79% 4.67% 4.59% May % 0.90% 1.69% 1.85% Jun % 5.70% 4.64% 4.52% Jun % 1.01% 1.73% 1.87% Jul % 5.66% 4.72% 4.56% Jul % 1.05% 1.73% 1.88% Aug % 5.73% 4.72% 4.55% Aug % 1.08% 1.70% 1.91% Sep % 5.78% 4.77% 4.59% Sep % 1.05% 1.65% 1.93% Oct % 5.71% 4.80% 4.47% Oct % 1.09% 1.68% 2.21% Nov % 5.72% 4.81% 4.47% Nov % 0.98% 1.65% 2.16% Dec % 5.90% 4.79% 4.41% Dec % 0.97% 1.81% 2.30% Jan % 5.86% 4.85% 4.33% Jan % 0.98% 1.83% 2.25% Feb % 5.90% 4.84% 4.30% Feb % 0.99% 1.81% 2.26% Mar % 5.97% 4.73% 4.24% Y/Y 3 bps -13 bps 14 bps 54 bps Y/Y -25 bps 6 bps 11 bps -28 bps *Combined BAC Intl. Bank and Banco BAC de Panama **Combined Banistmo and Bancolombia Panama Source: Superintendences of Finance; Serfinco S.A. 13

14 Colombia: Transformation is Underway; Heavy Construction and Banks, the Biggest Winners Local Government will initiate the construction of infrastructure projects with US$27 billion of investments made mostly between 2015 and After years of having poor and lagging infrastructure in Colombia (ranked 130 out of 148 countries in quality of roads according to the World Economic Forum) when compared to other economies in the region (only ahead of Paraguay), a huge revolution of the infrastructure sector is under way with several megaprojects. Construction phase is expected to start late 2015, led by the 4G Program and the PPP initiatives (Public Private Partnerships), under which US$23.5 billion in roads are estimated to be invested until Other, less certain, Government plans include US$3.05 billion in railroads, US$840 million in ports and US$270 million in airports; amounting a total investment of over US$27 billion. Colombian financial system (banks, pension funds, development agencies) could finance up to 80% of the US$25 billion. Colombian banks are the most favored entities to benefit from infrastructure development and investments. 4G and PPP contracting schemes have a less risk than the prior because equity requirements for constructors were raised from 10% to 20% of the project s total value and the disbursement of payments from the Government is made on the delivery of completed sections. The idea is to grant concessions after consulting communities, obtaining environmental licenses and land acquisitions (pre-construction) in an intent to transfer risks from licensees, constructors and financers to the Government. This, should lower risks in the construction and operation phases, but it would extend the pre-construction phase. However, regulation has not come through fully yet. Graph 21. 4G Project Financing Structure Source: Asobancaria; Serfinco S.A. Colombian Banking Association (Asobancaria) and management from different banks estimate that financing for 4G and PPP projects will add 1.5% to the system s loan portfolio growth -on average- over the next 5 to 8 years. The projects financing needs is big when compared to the size of financial institutions at 88% of technical capital and 16.5% of the system s outstanding loans as of Feb-14. This could set some restrictions over the system s capacity to disburse such amount. However, this risk has been moderated through 3 mechanisms: 1) new regulation raised the maximum exposure to an individual client from 10% to 25% of a bank s technical capital, 2) equity issuances and reserves re-allocation are going to be made over the course of the next 2 years to increase Tier I capital and strengthen technical capital and 3) structured finance proposals could enable standard securitization of projects through credit enhancement, facilitating loan rotation. Recent regulation enabled intangible assets and accounts receivable (among others) as guarantees for loans and created the National Guarantees Fund to make transactions more efficient and transparent. Asobancaria expects the full implementation of this reform will enhance financial inclusion (usage of financial products by Micro enterprises and SMEs, increasing competitiveness through leverage) and lessen credit risks, lowering allowances, provision expenses and therefore reduce interest rates. 14

15 The Housing Revolution in Latin America & Caribbean Latin American & Caribbean countries have considerable housing deficits and low financial penetration levels, which will enable growing mortgage and housing leasing demands from a rising middle-income class. In Colombia, growth of housing projects, housing demands and subsidy programs ( houses and interest rate subsidies for low-middle value mortgages - FRECH) will increase financing needs. During 2013, the housing loan portfolio (mortgages, securitized loans, leasing and Fondo Nacional del Ahorro) increased 19.4% to COP 40 trillion or 5.6% of GDP. We expect this segment to reach 6.4% of GDP in 5 years, with a positive outlook. Graph 22. Housing Deficits Across Latin America & Caribbean Graph 23. Mortgages / GDP (2013) Source: IADB Study: Latin America & Caribbean face an increasing housing deficit (2012). As a percentage of families. Graph 24. GDP Per Capita adjusted for PPP (US$ Thousand) Source: Superintendences of Finance and Titularizadora Colombiana; Serfinco S.A. Graph 25. Usage of housing loans Source: IMF s WEO 2013 Estimations for 2019; Serfinco S.A. Source: World Bank s FINDEX 2011; Serfinco S.A. Davivienda has presence in 2 of the 5 fastest growing countries in terms of GDP per capita adjusted for PPP for the next 5 years. Davivienda is going to profit from a rising purchasing power and shifting consumption trends as CA countries are becoming evermore globalized. These countries have signed several free trade agreements (CAFTA-RD, SICA, ACS, FTAA and potentially Pacific Alliance) and are increasingly important in international trade due to their strategic geopolitical location. 15

16 Valuation and Recommendation Loans were projected considering nominal GDP growth projections and an average multiplier of loan portfolio growth over nominal GDP growth, modeled further with perspectives on innovative channels and regulations that may help boost loan growth. We assume increasing market share over the next 5 years in Colombia (+35 bps), El Salvador (+25 bps), Costa Rica (+40 bps), Honduras (+12 bps) and Panama (+1 bps). Using the projected loan portfolio as a starting point, we apply an estimated Net loans / Funding ratio to obtain the total funding necessary. Equity was obtained through capitalization given an average payout of 30%. Interest income and expense were projected considering premiums or discounts to the projected driver rates for the bank: 1) Colombia s repo rate, 2) Colombia s projected Term Deposit Rate (DTF), 3) 6-month LIBOR USD, and 4) PRIME rate. Provision expenses were estimated by using projections of provision expenses as a percentage of average gross loans and trends in asset quality. Valuation Our valuation model consists on a weighted average of three valuation methodologies: i) dividend discount model (40%), ii) multi-stage excess return model (40%) over a 10 year period ( ) and a terminal value after 2023 at P/B implied multiple; and iii) regression of ROAE to P/B multiples for peers across Latin America (20%) and used it to obtain the expected P/B for 2014, given our ROAE estimations. Table 7. Evolution of Banks Number of Branches and Banking Agents (BA) in Colombia Source: Bloomberg; Serfinco S.A. Sensitivity Analysis Table 8. Valuation Sensitivity Analysis Source: Serfinco S.A. estimations 16

17 Relative Valuation Davivienda is fairly priced in comparison to its regional peers, when analyzing the trailing ROAE to P/B multiples. Currently, Davivienda is trading at 2.05x P/B with a 14.95% ROAE, in line with the regression to its major regional peers. Table 9. Relative valuation (P/B vs. ROAE-LTM) Source: Bloomberg, Company filings; Serfinco S.A. 17

18 Financial Statements SERFINCO s calculations on ratios have been standardized in our coverage universe, that is why figures displayed in this report may differ from the ones published by the company. - ROAE & ROAA: Full year net income / Average between beginning of period and end of period equity or assets. - Fee Ratio: Calculation include total fees and services income (including dividends). - Efficiency Ratio: Calculation include total expenses except for goodwill amortization. Table 10. Forecasted income statement Table 11. Forecasted balance sheet Table 12. Forecasted key ratios Table 13. Forecasted multiples E 2015E 2016E 2017E 2018E Asset quality PDL ratio (90 days) 1.62% 1.56% 1.55% 1.56% 1.55% 1.55% PDL coverage ratio (90 days) 255.2% 247.3% 245.2% 240.3% 239.7% 236.4% Allowances as % of gross loans 4.14% 3.87% 3.80% 3.75% 3.71% 3.68% Cost of risk (prov expense / avg. loans) 2.10% 1.90% 2.00% 2.13% 2.17% 2.13% Efficiency Operating efficiency (income) 53.9% 50.3% 48.2% 48.0% 46.9% 46.6% Administrative efficiency (assets) 4.40% 4.03% 3.83% 3.71% 3.60% 3.53% Fees and services income Fee ratio (income) 23.7% 21.3% 19.4% 17.8% 16.2% 15.1% Fee ratio (assets) 1.97% 1.73% 1.58% 1.41% 1.28% 1.19% Profitability NIM 7.11% 7.08% 7.14% 7.03% 7.07% 7.05% ROE 14.05% 15.80% 16.53% 16.17% 16.60% 16.92% ROAE 14.95% 16.78% 17.62% 17.21% 17.70% 18.07% ROA 1.51% 1.67% 1.70% 1.59% 1.64% 1.65% ROAA 1.64% 1.79% 1.83% 1.73% 1.75% 1.77% Regulatory capital Payout ratio 32.9% 30.0% 28.0% 29.0% 29.5% 30.0% Tier I 7.0% 7.3% 7.5% 7.6% 7.9% 8.0% Tier II 3.8% 3.7% 3.7% 3.4% 3.0% 2.6% Capital adequacy 10.8% 11.0% 11.2% 10.9% 10.9% 10.6% Table 14. Forecasted macro assumptions E 2015E 2016E 2017E 2018E GDP Growth Colombia 4.3% 4.6% 5.2% 4.5% 4.3% 4.2% El Salvador 1.7% 2.0% 1.7% 1.8% 2.0% 2.0% Costa Rica 3.8% 3.8% 4.1% 4.3% 4.5% 4.5% Honduras 3.1% 3.1% 3.4% 3.3% 3.1% 3.0% Panama 8.0% 7.2% 6.9% 6.4% 6.2% 5.9% Inflation Colombia 1.9% 3.2% 3.4% 3.3% 3.0% 3.2% El Salvador 0.8% 2.1% 2.6% 2.6% 2.6% 2.6% Costa Rica 3.7% 4.5% 4.0% 4.0% 4.0% 4.0% Honduras 4.9% 7.0% 6.0% 5.5% 5.5% 5.5% Panama 3.7% 3.6% 3.5% 3.3% 3.1% 2.5% Market share Colombia 12.19% 12.24% 12.32% 12.41% 12.47% 12.53% El Salvador 14.60% 14.70% 14.73% 14.75% 14.80% 14.80% Costa Rica 4.96% 5.11% 5.21% 5.28% 5.33% 5.35% Honduras 7.02% 7.14% 7.14% 7.14% 7.14% 7.14% Panama 1.46% 1.45% 1.46% 1.47% 1.47% 1.47% Colombia - rates Central Bank rate (average) 3.35% 3.54% 4.72% 5.25% 4.94% 4.52% DTF rate (average) 4.24% 3.99% 4.02% 4.28% 4.69% 4.25% 18

19 Historic Recommendation We are initiating Davivienda s coverage with a December 2014 target price of COP 31,300 and a BUY recommendation as of May 8, Source: Bloomberg; Serfinco S.A. estimations 19

20 International Equity Trading Desk Andres Jimenez Juan P. Vieira Andres Gomez Head of Electronic Head of Equity Head of Trading Trading (574) (574) (574) Jose F. Restrepo, Daniel Marin Andres Upegui CFA Equity Trader FX Trader Equity Strategist (574) Ext. (574) (574) Research Team Maria Velásquez Rafael España Alejandro Isaza Cement and Energy and Utilities Consumer Services and Holdings Construction (571) Ext. (574) Ext. (574) Ext Nicolas Noreña Financial Services (571) Ext Bogotá Centro de Negocios Andino Carrera 11 No Piso 6 Tel: (571) Medellín San Fernando Plaza Torre 1 Carrera 43A No Piso 10 Tel: (574) Cali C.C. Unicentro Torre Oasis Oficina 722B Tel: (572) Bucaramanga Metropolitan Bussiness Park Carrera 29 # of 910 Tel: (577) Cartagena Torre Empresarial Protección Carrera 3 No 6A 100 Of. 801 Tel: (575) Barranquilla Centro Empresarial Las Américas Calle 77B No Tel: (575) The analyst certifies that the opinions expressed in this report accurately reflect his personal opinion about the company of concern. Also, the analyst certifies that he has not received, is not receiving and will not receive any direct or indirect payment in exchange for expressing a specific recommendation in this report. Serfinco S.A. is committed to provide independent and objective research for all the companies in the coverage universe. During the normal course of business, Serfinco S.A. intends to obtain revenue for banking investment services from all the companies in the coverage universe. The remuneration for the analyst is based, in part, on the profitability of the firm, which includes investment banking and revenues from sales. The research analyst does not have a position in the fixed positions of this covered company and does not provide any kind of services to the company. The research analyst has not taken part in any investment banking transaction of the company in concern. Serfinco S.A. was not making a market in the titles of the company in concern when this report was published. In the last twelve months, Serfinco S.A. did not receive, nor it is authorized to receive, revenues for investment banking services, services related to the title of non investment banking, or non title services rendered to the company in concern. that could affect the objectivity of this report. Therefore, investors should consider this report only as a factor for their investment decision making. However, Serfinco S.A. intends to do business with the companies covered in this report. Consequently, investors should be aware that the firm might have an interest conflict. 20