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* CEO Portela sees defaults easing in first half
* Shares decline as earnings quality disappoints
* Recurring profit beats forecast in Reuters poll
* Rise in defaults weighs on parent's profit
By Guillermo Parra-Bernal and Aluísio Alves
SAO PAULO, Jan 31 (Reuters) - Fourth-quarter profit at Banco Santander Brasil SA disappointed investors despite beating analysts' expectations, raising questions about the ability of Brazil's largest foreign lender to stem the impact of record-low borrowing costs and rising delinquencies.
Interest income dropped to the lowest level in a year, fee income rose but fell short of expectations, and expenses topped analysts' forecasts, the bank reported on Thursday. The results confirmed the extent to which lower interest rates are weighing on profits and highlighted the bank's struggles in dealing with stubborn defaults as the Brazilian economy enters a third year of sub-par growth.
Santander Brasil, a subsidiary of Spain's Banco Santander SA , earned recurring profit, or income excluding one-time items, of 1.598 billion reais ($803 million), up 6.5 percent from the third quarter. In a Thomson Reuters poll, six analysts forecast, on average, recurring profit of 1.29 billion reais.
Santander Brasil shares fell as much as 3.2 percent on Thursday after investors balked at Chief Executive Marcial Portela Alvarez's strategy of aggressively trimming bad-loan provisions to bolster profits and offset the impact of sliding revenue and rising delinquencies. Profit was also propped up by an abnormal slump in the effective tax rate for the quarter.
"The headline beat doesn't tell the story," JPMorgan Securities analysts led by Saul Martinez wrote in a note. "Santander Brasil remains a 'show me' story, in our view."
Management cut bad-loan provisions to 3.096 billion reais, the lowest level in three quarters. The banks has cut such provisions, the amount set aside to cover credit-related losses, by more than 700 million reais in the past two quarters.
As banks in Brazil have failed to accurately predict default trends in the past two years, they have had to increase bad-loan provisions. Unlike peers, Santander Brasil saw delinquencies rise in the fourth quarter, and forward-looking indicators signaled this trend would continue.
Loans in arrears for 90 days or more, the benchmark for delinquencies, rose to the equivalent of 5.5 percent of its loan book, compared with 5.1 percent in the third quarter. Analysts expected a so-called default ratio of 5.2 percent.
According to Credit Suisse Group analysts led by Marcelo Telles, Santander Brasil is under-provisioned by between 700 million reais and 1 billion reais at current default levels. "We do not believe the bank will be able to sustain provisions at such low levels vis-à-vis the asset quality deterioration in the quarter, and a pick-up should be expected," they wrote in a note.
Portela Alvarez, speaking at a news conference in Sao Paulo, said defaults are "not a worrisome issue for us." He expects delinquencies in the corporate loan book to start easing in the first half of the year, with consumer defaults falling before year-end.
Part of the spike in delinquencies in the fourth quarter was because Santander Brasil "put the brakes on loan renegotiations, especially with consumers," he said. For several quarters, analysts have pointed to the high level of credit renegotiations as one of the biggest risks for Santander Brasil's asset quality performance.
Compared with the 2011 fourth quarter, recurring profit dropped 2.7 percent. Investors in Brazil follow quarter-on-quarter results more closely than annual comparisons.
The jump in bad loans in Latin America's largest economy weighed on the parent company's 2012 results. The Spanish giant Banco Santander struggled last year as defaults rose in Latin America and particularly in Brazil, which generates 26 percent of its earnings and where growth is faltering.
Santander Brasil's net interest income, or proceeds from lending transactions excluding funding costs, fell to 4.717 billion reais from 4.883 billion reais in the third quarter. Fee income, or revenue stemming from insurance, brokerage and investment-banking services, rose 3 percent, well below expectations in the poll.
Lending rose 2.2 percent from the third quarter to 211.96 billion reais but was below estimates of a 3.7 percent gain. Expenses rose 3 percent, below the poll's estimate of 4.6 percent.
The annualized return on average equity at Santander Brasil rose to 12.2 percent from 11.7 percent in the third quarter. ROE, a widely used indicator for profitability in the sector, was 13.5 percent a year earlier. Analysts in the poll expected 9.9 percent.
Loan book growth at Santander Brasil confirmed a trend of slow expansion among private-sector lenders. On Monday, Banco Bradesco SA reported weak growth in disbursements as demand for fresh credit remains subdued.