The tough actions taken over the past few years crystallised in Q1 21, with Arion Bank posting its strongest quarterly result since Q2 17. There were positive takeaways from multiple angles; revenues, operating and risk costs, balance sheet growth. While the bank may not be able to enjoy such a confluence of positive influences over the coming quarters, we do see scope for strong earnings growth over the coming years. The possibility that the planned ISK50bn capital distribution to shareholders is accelerated adds gloss to the investment case. The shares currently trade at 15.2x 2021 earnings and 1.2x book value. Key downside risks include likely pressure on margins and disruption to the global vaccine rollout, which is key to a recovery in tourism.
Q1 21 results summary
Arion Bank reported ISK6.0bn net profit, versus ISK2.2bn loss in Q1 20 and an ISK5.8bn profit in Q4 20. ROE was 12.5% and ROA 2.1%. Operating income, operating costs and risk costs all contributed to the strong performance. We provide more details below.
With all adults likely to be vaccinated by end-June, management expects Iceland's economy to improve in Q3; this supports the asset quality outlook. Mortgages will remain the main engine of loan growth; house prices are rising and transactional activity is robust, helped by a combination of rising real wages and low interest rates. The net interest margin should remain within a 2.6-2.8% range (Q1 21: 2.7%). The capital return strategy appears to have strengthened, although the target of returning ISK50bn to bring down the CET1 ratio to 17.0% is unchanged. Arion forecasts 3.3% GDP growth in Iceland in 2021, after 6.6% contraction in 2020.
Digital leadership continues
Arion Bank is the domestic leader in digital banking and also scores well versus global peers. One recent milestone has been the implementation of a new core banking system, Sopra, that went live in April. This will help streamline processes, shorten development cycles and support Arion’s open banking journey. The overall impact should be to lower operating costs and risk, and help improve customer engagement and cross-selling. The total cost of this project has been ISK4bn; this has been capitalised and will be amortised over the coming 10 years.
Q1 21 results
This increased 46% yoy; core income advanced 4% yoy. The ratio of operating income/risk-adjusted exposure amounts was 7.0%, above management’s 6.7% medium-term target.
Net interest income (up 1% yoy). Asset yields have been on a downward trend as the central bank followed international peers last year and cut its base rate several times, such that it now stands at just 0.75%. During 2020, Arion was able to offset lower yields through reduced funding costs; deposit-gathering has been strong. However, the scope for lowering funding costs further appears limited; almost three-quarters of deposits are demand deposits, for example. We expect further modest margin pressure over the coming quarters, due partly to the growing weight within the loan book of lower-yielding mortgages and reducing exposure to CPI-linked loans.
Fee income (up 7% yoy). Positive growth in asset management, corporate finance, capital markets and lending fees were offset by lower payments-related fees. The latter is expected to improve in H2 as the economic situation normalises.
Net insurance income (up 34% yoy). Performance benefitted from unusually low claims. In recent years, Vordur has been able to reduce its combined ratio even as its market share has risen from below 15% in 2016 to 17% last year. Closer integration with the retail bank should support further market share gains.
Net financial income was ISK1.5bn, versus ISK2.0bn negative amount in Q1 20. The main driver of the positive performance was the equity portfolio, which benefitted from strong market performance.
These fell 3% yoy. The cost/income ratio was 46.2%, down from 69.2% in Q1 20, but slightly above the level of more recent quarters. Staff costs rose 5% yoy, as wage increases and redundancy costs offset a 5% yoy reduction in the number of full-time equivalent employees. In contrast, other operating expenses fell 10% yoy. Looking ahead, management indicated there is scope to reduce IT and housing costs, which together account for around half of non-staff costs.
Arion Bank recorded a net impairment release of ISK1.1bn, versus a net impairment charge of ISK2.9bn in Q1 20. The main driver was a shift of some Stage 2 Loans into Stage 1 based on improved credit ratings and higher collateral values. The outlook for this line item will be closely linked to the opening up of the economy to international tourism.
The loan book grew 2% ytd and 7% yoy. Mortgages (up 4% ytd and 24% yoy) are the main growth driver. In terms of asset quality, the proportion of Stage 3 loans was stable yoy at 2.9%, although there was a slight increase from the 2.6% level of Q4 20.
The volume of Covid-impacted loans is c11% of the overall loan book; of this amount around three-quarters is tourism-related. 11% of these loans (ie 1.3% of the total loan book) are in Stage 3.
Customer deposits increased 4% ytd and 10% yoy. Demand deposits are approximately three-quarters of the total.
Capital and liquidity
Despite distributing ISK14.8bn to shareholders in Q1 (ISK2.9bn dividend and ISK11.9bn buy-back), Arion’s capital ratios remain at elevated levels. THE CET ratio is 22.4% versus management's 17.0% target and the regulatory floor of 13.5%. Arion still has ISK41bn equity above its CET1 target, and management has reiterated its intention to return ISK50bn to shareholders in the coming years. Indeed, we think the strong result this quarter, and the more favourable outlook could encourage management to accelerate the distribution programme. If completed in 2022, this would imply a 16% annual yield to shareholders (via dividends and buy-backs, averaged over 2021 and 2022).
Over the next five years, the volume of maturing debt will average cISK50bn pa. However, in the context of plentiful liquidity and a strong capital base, these maturities should not be a source of strain.
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