Arion Bank reported Q3 22 net profit to shareholders of ISK4,869mn, down 41% yoy, which was 20% below our expectation and 17% below the company-compiled consensus. The pre-tax result was 6-7% below our projections and consensus. The main reasons for the weak performance were negative net financial income, high insurance claims and a high effective tax rate. Key positives include the net interest margin, good cost control and high loan quality.
The shares have declined 17% so far this year and are now trading at 9.8x 2023 earnings and 1.5x 2022 tangible book. Relative to other frontier and emerging markets, Iceland is sheltered from energy cost volatility, benefits from a well-off, highly educated and digitally connected population, and is a market where pro-active monetary policy appears to be approaching the end of the tightening cycle.
The biggest investment risks are largely related to the global macro cycle, which could affect the tourism industry and capital flows. The local real estate market has weakened in recent months, but the recent moderation in the pace of monetary tightening suggests policymakers are cognisant of the dangers of squeezing the economy too hard.
Q3 22 results: Key positives
Net interest income was better than expected, as margins continue to be buoyed by higher asset yields. However, with the central bank’s recent 25bps hike suggesting the tightening cycle is nearing its end, further improvements are likely to be more modest.
Operating costs were lower than forecast, rising 4% yoy, with non-staff costs being particularly well-controlled. The average headcount grew by around 1%.
The bank continues to see net impairment provision write-backs, as expected. This was driven by recoveries of previously written-off loans, which more than offset some more cautious modelling assumptions. The proportion of Stage 3 loans also continues to gently decline. One concern we have is that the level of provisions, relative to total gross loans and Stage 3 loans, is modest (0.8% and 55%, respectively). If collateral values fall or delinquencies increase this could apply a substantial risk cost load to the income statement, leading to an overshoot versus the company’s credit risk cost estimates (which are currently 21bps over-the-cycle 21bps and 25bps over the next 12 months).
Strong liquidity position. Arion now has no bonds maturing until 2024, which provides protection against potential market turmoil. Liquidity ratios remain strong (LCR 189%, NSFR 119%).
Substantial excess capital generation. Although the near-term prospect for capital distributions has deteriorated (see below), continued price, cost and capital discipline should ensure that capital distributions in excess of the 50% target payout ratio should be possible in most years.
Q3 22 results: Key negatives
Fee income was lower than expected, registering 7% yoy growth (versus 18% yoy growth in H1 22). The key source of weakness was loan and guarantee fees (down 18% you); refinancing activity has slowed given higher interest rates, plus Q3 21 did not see the usual seasonal drop off in this fee line as borrowers looked to secure credit ahead of the turn in the rate cycle. Although resilient, given the tough capital markets backdrop, asset management fees also fell (by 15% yoy).
Net financial income was substantially negative, although this was expected given the challenging equity and fixed-income markets. Arion is more exposed to this source of volatility than its large domestic banking peers, partly due to its extensive insurance operations.
Insurance income fell 30% yoy, Although premium growth was a healthy 10% yoy, claims rose 28% over the same period, largely due to a period of poor weather towards the end of September, which drove higher motor and travel-related claims, including one large claim.
The effective tax rate was 37%, against our 29% expectation. Much of the sizeable investment losses are not tax-deductible.
The CET1 ratio target has been raised from 17% to a 150-250bps cushion above the management buffer, which currently translates to a 17.2-18.2% target range. This has reduced the scope for capital distributions by between ISK1.7-10.4bn. It therefore lessens but does not remove one of the key differentiators to Arion Bank’s investment case; excess capital currently stands at ISK9-18bn. We would expect the current ISK10bn buy-back programme (split into two ISK5bn tranches, of which the first is ongoing) to be completed by year-end with either an enhanced full-year dividend or further buy-backs extending the capital distribution story into next year.