Company Analysis - Commissioned /
Iceland

Arion Bank: Q2 results beat on higher revenues, low risk costs; capital return story intact

  • Q2 positives: fee income, credit risk costs, discontinued operation results. Tax and financial income were negatives

  • Fundamental improvements to revenue generating capacity, plus cost and capital discipline, are lifting ROE potential

  • Despite macro clouds (higher interest rates will stymie credit demand) the capital return story remains intact

Arion Bank: Q2 results beat on higher revenues, low risk costs; capital return story intact
Rahul Shah
Rahul Shah

Head of Financials Equity Research

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Tellimer Research
1 August 2022
Published byTellimer Research

Arion Bank reported Q2 22 net profit of ISK9.7bn, a rise of 24% yoy, in line with the company-compiled consensus but above our expectation of ISK8.3bn. Although the result from continuing operations was broadly in line (ISK2.9bn actual versus our ISK2.8bn estimate), results from discontinued operations surprised positively (ISK6.9bn against our ISK5.5 projection). Other key variances were fee income, risk costs and other operating income (positive); and financial income and taxation (negative) – see the results table below.

Looking ahead to FY 22, loan growth is likely to slow from the current robust rate (20% yoy). Based on current trends, Arion could surprise positively in relation to fees and risk costs, but macro shocks or funding disruption could quickly change the picture.

We maintain our fair value estimate at ISK210. At their current price of ISK176, the shares are trading at 9.8x 2023PE and 1.6x 2022 tangible PB.

Key risks relate to the outlook for the housing market, which the central bank is trying to cool. If higher interest rates (which are up 400bps over the past year) lead to a sharp reduction in credit demand, this could damage asset quality. Together with tighter funding conditions, this could prompt a re-evaluation of the capital release timetable.

Macro environment

Iceland continues to demonstrate positive data, with Q1 GDP growth surprisingly strong at 8.6% and Q2 also likely to be robust, given booming card transaction data and the strong inbound and outbound tourist data. Fish and aluminium exports are benefitting from rates that are off their peaks but still higher than in prior years. At the same time, the economy is less exposed to elevated hydrocarbon prices due to Iceland’s geothermal energy capacity.

The unemployment rate is down to pre-Covid levels, while the proportion of firms reporting hiring difficulties is at the highest level since 2007. 85% of wage agreements will be renewed over the next nine months; the results of these negotiations will have a significant bearing on the medium-term inflation outlook. A key driver of the current inflation spike is housing costs; property prices have increased by over 20% over the past year. Further background can be found here.

Clearly, the economy is running near to full capacity. The central bank is trying to engineer a slowdown via higher interest rates and tighter mortgage lending restrictions. Still, for a small and open economy, this is a difficult exercise (as history shows). The structure of the Icelandic economy has changed since 2008, however. And Arion Bank appears vigilant to the risks; mortgage lending has slowed and the firm is signalling a moderation in corporate lending growth in H2.

We view a sharp macro slowdown as the key risk to the investment case.

Commitment to capital distribution remains strong, but the outlook is less clear than before

The Valitor sale, which has finally closed, will release ISK13.8bn capital (via capital gains and a reduction in risk exposure amounts). We estimate Arion Bank currently has ISK23bn capital (above management’s 17% CET1 target) that could be distributed as buy-backs, in addition to a 50% dividend payout. Distributions over the next year could therefore approach a combined ISK40bn, equivalent to 15% of the current market cap.

Since the beginning of 2021, Arion has distributed ISK58bn equity capital to its shareholders via buy-backs and dividends, and the commitment to optimise the capital structure remains strong. But we think any sharp deterioration in the economic environment or significantly tougher funding conditions (wholesale spreads have already widened) could prompt a temporary re-evaluation.

Q2 results: Healthy core revenues offset by investment losses

Key positives

Fee income. Up 27% yoy, and a record quarter for the bank. All major fee lines were strong, with Capital markets and corporate finance (+50% ) and Lending and guarantees (+30%) key drivers. Despite the challenging capital markets, asset management inflows were solid, allowing this area to post 9% yoy growth. In the future, payments fee income will benefit from an ISK200mn-300mn quarterly contribution from Valitor (previously recorded under the discontinued operations line). However, lending fees may moderate as higher interest rates limit corporate credit demand, and capital markets fees may also struggle to reach the record Q2 level.

Other operating income was boosted by gains of almost ISK650mn on foreclosed assets.

Operating costs rose 4% yoy, below inflation, with the headcount stable and IT costs falling. In the future, operating costs will benefit from having no contribution to the deposit guarantee fund; in 2021, the impact of this line item was ISK558mn for the full year. On the other hand, it is likely that IT expenses could rise as some new investments are planned. Another factor to consider is the staff incentive scheme, which could cost up to ISK1.6bn if all conditions are met. The charge for this will likely take place in Q4; ISK0.4bn accruals have already been recorded in the balance sheet.

Credit risk costs. Asset quality continues to improve with both Stage 3 (now 1.4% of loans) and Stage 2 (6.6%) ratios declining. Allied to some recoveries, this allowed the impairment charge line to make a positive contribution to the bottom line. The positive outlook for the tourism sector is supportive, given that this sector accounts for almost half of all loans subject to forbearance/moratoria/default.

Discontinued operations. Results came in at ISK6.8bn, above our ISK5.5bn forecast. Although the gain on sale from the Valitor disposal was in line (ISK5.6bn), it also posted a positive operating result (ISK0.6bn) and there was an ISK0.5bn contribution from the Solbjarg travel business.

Customer balances. Loans grew 20% yoy and 8% in H1 but momentum is likely to slow, in our view. Higher interest rates are reducing mortgage demand and will also over time affect corporate credit. In addition, we expect the sale of corporate loans to continue (ISK14bn so far in 2022). Deposit growth was 20% yoy, with core deposits increasing 16% yoy and good growth in balances from SMEs and pension funds. 95% of deposits are short-term (<3 months maturity). With funding costs rising, investors should remain vigilant to any drying up of liquidity.

Key negatives

Funding costs are rising sharply, up 80% yoy, reflecting the 400bps rise in the policy rate over the past year (to 4.75%). Although these higher costs are being offset by higher asset yields (up 47% yoy) if competition for funding were to increase (either for deposits or in wholesale markets) it could put pressure on Arion’s margins and/or funding volumes.

Net financial income posted a ISK2.9bn loss, a record negative amount for the bank. Both equities and bonds contributed to this negative picture. Note that ISK1.9bn of this figure represented a transfer from OCI due to a previous accounting classification error (and is, therefore, capital neutral).

High effective tax rate (55%), which reflected the losses on financial assets and distortions from the ISK1.9bn reclassification highlighted above.

Other comprehensive income remains in negative territory once the ISK1.9bn reclassification is adjusted for. This primarily reflects valuation declines in the investment portfolio that are not immediately marked to market in the income statement. If these losses are realised in the future, it could put negative pressure on reported profits.

Total loan loss allowances are now equivalent to just 0.7% of loans, down from 1.4% at end-2020. Since asset quality has been improving, this reduction has not affected coverage ratios (which have increased to 55% of Stage 3 loans). However, as we enter a period of macroeconomic uncertainty, the absolute level of provisions now looks to be on the low side. Even a small deterioration in credit quality would see the provisions coverage ratio plummet, lifting credit risk costs above the 24bps guidance.

Arion Bank: Q2 2022 results