Arion Bank reported Q1 22 results that were in line with our forecasts and slightly better than the company-compiled consensus. Net interest income was the main positive element, while fee income, insurance income and credit risk costs were worse than expected. Looking ahead, our core forecasts are largely unchanged (with higher risk costs offsetting better net interest income), although we lift our headline net profit for this year due to the raised sale price for payments firm Valitor. Further detail is provided in the Appendix.
Our fair value estimate remains ISK210. We expect the company to continue returning capital to shareholders via buybacks and dividends as cost and capital efficiency continue to improve. Based on our estimates, the shares are trading at 8.8x 2022 PE and 1.5x tangible PB. Our mid-cycle ROTE estimate is 16.2%.
We think the key investment risk relates to the macro environment; external inflationary pressure is being exacerbated by a buoyant local housing market, low unemployment and expansionary fiscal positioning. Although the central bank has moved early and hard (interest rates have been increased by 300bps since November 2020), its ability to be more aggressive is constrained, as high rates will generate foreign capital inflows. Real interest rates thus remain firmly in negative territory. While the economy is more diversified than in the past, the spectre of a hard-landing continues to lurk in the shadows.
Key positives from the Q1 22 results
Net interest income rose 30% yoy, with margins up 37bps versus Q1 21. The bank is benefitting from the 300bps increase in policy rates since November 2020 (with the latest 100bps increase taking place on 4 May). Most of its loans are variable rate, while three-quarters of deposits are non-interest-bearing. Looking ahead, it is worth noting that not all assets and liabilities have yet repriced to the new interest rates. A shift in loan mix towards corporates is also beneficial for margins.
Non-staff costs fell 8% yoy. Management continues to keep a close eye on cost efficiency. All major cost categories declined. Although an ISK1bn IT investment programme was earmarked for this year, some of this has been deferred given the more uncertain global macro environment following Russia’s invasion of Ukraine.
Loan volume increased 17% yoy and 4% in Q1. The primary driver for the year-to-date growth was corporate lending, spread across real estate, construction, information technology, wholesale & retail trade, industry, energy & manufacturing. The bank has a strong pipeline of future corporate loan deals. Even as it delivers balance sheet growth, and in keeping with its focus on capital efficiency, Arion continues to offload corporate loans from its balance sheet; ISK4bn loans were sold in Q1, after ISK30bn of such deals in 2021. In contrast, mortgage volume growth was weak (just 1% growth in Q1, after 22% in 2021); Arion has stepped back from some products due to unfavourable pricing.
Key negative elements to the Q1 22 results
Fee income fell rose 8% yoy but fell 24% qoq. Key drivers of the sequential decline were loan fees (the bank has stepped away from some keenly-priced mortgage products), asset management (tougher environment for performance fees) and lower card, payments and collection fees. Note that fee income was particularly buoyant in 2021 (up 26% on 2020), making for a tough base on which to build.
Insurance income collapsed, from a run rate of around ISK850mn per quarter to close to zero. The main culprit was higher claims (95% claims ratio in the quarter); these were at depressed levels during Covid-lockdowns but have bounced back as the economy has re-opened. Claims levels should normalise as the pent-up demand is met, but visibility on when exactly this could happen is limited. Gross written premiums advanced at a healthy 10% yoy rate.
The cost of risk increased to 20bps (negative previously), which is in line with management's mid-cycle guidance. Although loan quality data continues to improve, management has elected to take a more cautious view of the outlook given rising geopolitical uncertainty and higher global inflation. While we commend this cautious approach, we are concerned that there is now limited slack in the economy, meaning that attempts to moderate demand will need to be actively managed.
Other comprehensive income remains in negative territory. Rising interest rates are harming the valuation of the bond portfolio. We note that this portfolio is smaller than in the past, which should help to moderate this drag on performance in future.
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