We have raised our mid-cycle ROE estimate from 13.8% to 15.8%, which supports an increase in our fair value estimate from ISK180 to ISK210 per share. Key drivers of our more positive assessment include a stronger top line, helped by the rapid recovery of the Icelandic economy and Arion Bank’s successful cross-selling efforts. Greater exposure to mortgages is beneficial from a risk costs perspective. At our new fair value estimate, the shares would trade at 11.6x 2022 earnings and 1.8x book value.
Forecast changes
We raise our mid-cycle ROE forecast for Arion Bank from 13.8% to 15.8%. Key drivers of this more positive view include:
Raised volume growth projections. The Icelandic economy’s recovery from the global pandemic-related recession has been stronger than we expected, helped by accommodative monetary policy and an aggressive vaccine rollout that has helped tourism to rapidly bounce back.
Stronger fee income. Management has been able to shift to a more returns-focused approach, particularly for corporate and SME clients, which is driving improved fee income generation. Other factors include a recovery in lending appetite.
Higher insurance income. Closer integration of the insurance and banking businesses should improve cross-selling rates and allow Vordur to improve its market share.
Improved cost control. Headcount reductions, reduced physical footprint and increased automation all contribute to greater cost efficiency. The profit-share scheme has lifted staff costs but has also more closely aligned the interests of the workforce and shareholders.
Lower risk costs. The stronger macro outlook and increased weighting of mortgages within the portfolio have contributed to a more benign assessment of the credit quality outlook.
Fair value estimate raised to ISK210 from ISK180 per share
We value Arion shares using a target price book model. Our cost of equity is 12% and our terminal growth rate assumption is 5%. Our mid-cycle ROE estimate is 15.8%. Our model also captures the discounted present value of forecast capital distributions in the period to 2024.
At our new fair value, the shares are trading at 11.6x 2022 earnings and 1.8x book value.
Strong FY 21 result supports our more positive view
Arion Bank’s FY 21 net profit of ISK28.6bn (+129% yoy) was 7% above our ISK26.7bn forecast, and 4% above the company-compiled consensus. Return on equity came in at 14.7%. Key areas of positive surprise were fee income, loan provision recoveries and results from discontinued operations.
Key positives
Net interest income was boosted by strong volume growth and higher margins. The recent 75bps hike will support further margin improvements in 2022.
Strong fee income (up 26% yoy) boosted by strong loan and guarantee fees and good capital markets income. We note that the volume of off-balance sheet undrawn loan commitments has increased by 70% over the past year and points to a strong corporate lending pipeline.
Net financial income was stronger than expected, driven by the ISK25bn equities portfolio.
Solid net insurance income, driven by US$12 premium growth and an improved combined ratio of 93%. Vordur's ROE was over 25% in 2021.
Net provisions releases continued, as Covid-related provisions were reversed and the volume of Stage 3 loans declined. There are now very few loans on the books that are still subject to moratoriums.
Other income sources were also stronger than expected, notably real estate disposal gains and fair value gains.
Strong loan growth (+14% yoy), with mortgages the key driver (+23% yoy). Looking ahead, there is likely to be a more balanced mix of growth, as higher interest rates stem mortgage refinancing volume, and as the economic recovery supports corporate investment activity.
Healthy deposit inflows, with balances rising 15% yoy. The majority of deposits are interest-free (76% are demand deposits), meaning margins should receive a boost from higher interest rates rise.
Large dividend payment (ISK15 per share), equivalent to 79% of earnings and signalling the bank’s continued commitment to returning excess capital to its shareholders.
Key negatives
Operating costs were higher than expected – with higher staff costs arising from the profit share scheme and higher amortisation costs offsetting reductions in IT costs and housing expenses. Profit share costs are likely to continue this year, and the firm has also announced a programme of IT investment that could cost up to ISK1bn. Nevertheless, we expect the cost/income ratio to maintain its downward trajectory as top-line growth and efficiency improvements take effect.
The effective tax rate was higher than expected, at 20%. We expect a further increase in this ratio as net financial income wanes.
Appendix: Financial forecasts
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