Description

Arion Banki

The Icelandic banking industry has fully recovered from its total collapse during the crisis and now features limited and rational competition among three banks. Today, Icelandic banks are almost entirely domestically focused, have less risky balance sheets focused on domestic SME, corporates and mortgages and are heavily overcapitalized.

After the financial crisis, Arion Banki was established on the ruins of former Kaupthing Bank and placed in control of the old bank’s domestic assets and liabilities. More recently, Arion Banki was the first of the three Icelandic banks to go public in June 2018 and regain access to markets. Today Arion is a profitable, but heavily overcapitalized bank that has committed to returning excess capital to shareholders and cutting costs. This will be achieved through a combination of dividends, share buybacks, as well as spinning out Valitor, its valuable but subscale payments business. The combination of the two makes for a unique setup where Arion has the potential to increase ROE by reducing costs and returning capital to shareholders. A base case IRR of 21% over a 4-5 year is highly achievable on conservative assumptions.

Historical Background and Market Structure

Arion Banki was formed out of the ruins of Kaupthing on 18 October 2008 as New Kaupthing hf., changing its name to Arion Banki on 21 November 2009. As a quick of the last crisis: All three of Icelands banks expanded rapidly overseas, mostly through wholesale deposits and online savings products[1]. The combined foreign debt of the three banks was five times Iceland’s GDP. A reliance on wholesale funding combined with credit issues led to fears that the banks would not be able to refinance their debt in the wake of the Lehman collapse. A subsequent run on the banks’ deposits led to a rapid depletion of liabilities. While the Icelandic government guaranteed “that deposits in domestic commercial and savings banks and their branches in Iceland will be fully covered.”[2], overseas depositors in the UK, Finland, Norway, Germany and Austria were not. This resulted in the “Icesave” dispute, which revolved around whether former overseas depositors of “Icesave”, Landsbankinns online savings product should be made whole by the Icelandic government. This was rejected through a series of referendums by the Icelandic population so that finally the problem was referred to the EFTA court which cleared Iceland of all claims.

Today, Iceland’s banking market is a triopoly with Arion Banki, Landsbankinn and Islandsbanki each holding about a third of the market share. The banks are much simpler, domestic businesses with almost no overseas activity. Wholesale funding still exists but it is almost entirely done through asset-liability matched covered bonds. There is some competition from Pension funds in the mortgage space, while Nordic Banks compete in investment banking. Outside of these two segments Iceland today is a highly stable market with limited competition.

Banking is no different from other industries in that high market share and limited competition tends to be associated with high profitability. A more prominent example of this can be found in the Canadian banks which periodically are written up as a short but tend to do fine in almost every environment due to an oligopolistic market structure and strong pricing power evidenced by a persistent ability to overcharge customers for financial services.

As of this writing, Kaupskil owns 20% of Arion Banki while Taconic owns about 16%. Attestor Capital, Goldman Sachs and Och-Ziff are also involved with smaller minority stakes. Kaupskil is 100% owned by Kaupthing hf., which is still being run-down for the benefit of creditors and claimholders. While it is unclear who exactly stands behind Kaupskil and Kaupthing hf., it represents a mix of creditors and claimholders to the former Kaupthing. The sources of recovery for Kaupthing creditors and claimholders are 1/ running down Kaupthings international assets and 2/ sale of Kaupskil’s stake in Arion. Kaupskil and Kaupthing do not have recourse to Arion beyond the value of their equity stake in the bank.

Finally, there is an agreement in place which specifies that Kaupskil has to run down its stake in Arion Banki in order to recover proceeds for creditors and claimholders. Regulators and the Icelandic government are also pressuring Kaupskil to accelerate its disposition of its Arion stake. In other words, Kaupthing/Kaupskil will not wait around until Arion Banki has reached its intrinsic value or paid out excess capital to shareholders, it is a forced seller and a large part of the reason why the stock price remains depressed. Kaupskil also was the main seller in the IPO. Since then it has sold 11% of Arion’s total shares outstanding in an additional equity offering in April and another 5% directly to Taconic. Management and employees of Arion on the other hand were significant buyers in the IPO.

Capital and Capital Return

Arion has a CET1 ratio of 21.2% and an additional 80bp of Tier 2 bonds outstanding, leaving Arion with a total capital ratio of 22%. Arion’s regulatory CET1 capital requirement is only 16.5% while its total capital requirement is 21.3%. The difference between Arion’s CET1 ratio and its regulatory CET1 capital requirement represents approximately how much the bank can afford to return to its shareholders via dividends. This would be done by replacing CET1 capital above the regulatory CET1 capital requirement by issuing additional Tier 1 and Tier 2 bonds. Assuming Arion wants to keep a 1% management buffer above its regulatory capital requirements, Arion could issue 2% additional Tier 1 Bonds and 1.9% more Tier 2 bonds for a total of 2.7% of Tier 2 Capital. This would increase its total capital ratio to 25.9%. With risk-weighted assets of ISK 797bn, Arion could reduce its CET1 and total capital ratio 3.7%, or ISK 29.5bn while still maintaining a 100bp buffer above regulatory capital requirements. This would bring Arion’s CET1 ratio to 17.5% and its total capital ratio to 22.2%, both comfortable above regulatory requirements.

Currently Arion is generating earnings of ISK 12bn per annum and paying out about -18bn per annum in dividends. At a rate of ISK -6bn per annum, assuming no earnings growth, Arion will have paid out its excess capital in five years. By reducing CET1 from ISK 169bn to ISK 139bn, Arion would also be lifting its ROE to 8.6%. Assuming this improves the exit price to book multiple to 0.86 from the current level of 0.69 (price of 71.7 per share in 2023), Arion Banki can conservatively generate an IRR of 12.7% just by paying out ISK 18bn in dividends per annum. The underlying cashflows would look as follows:

Currently Arion is actually on an accelerated path to implementing this plan by using excess capital for a combination of paying out dividends (13%) and buybacks (8.4%) for a total dividend and buyback yield of 21.4%. I can’t say for sure whether this accelerated pace of capital return will last and am intentionally assuming a slower pace of capital return.

Additional Upside from Sale of Valitor

The above-mentioned IRR of 12.7% increases to 20.9% if Valitor is sold for ISK ~24bn. In this case, Arion’s run rate earnings also increase by ISK +2bn from decreased losses stemming from Valitor (not taken into account in the IRR calculation).  

While Valitor has seen top line double digit growth since 2012, it remains slightly loss-making due to lack of scale and ongoing investments. Management has recognized that Valitor needs outside support to further boost growth and is contemplating either a spinoff, bringing in a JV partner or a complete sale of the business. With Valitor contributing about ISK -2bn in losses in 2018 compared to ISK 12.5bn in operating income at Arion, a sale of Valitor could significantly improve Arion’s efficiency ratio as well as make further excess capital available to return to shareholders. While it is difficult to come up with a precise point estimate for the sale of Valitor, a price of ISK 24bn would equate to 4x sales or 1.5x book, a value that is well-supported by both precedent transactions and publicly traded comps. For example, Nexi, a more mature and slower growing competitors just IPO’d at >4.5x revenues while Network International, a faster growing middle eastern payments business IPO’d at >8x revenues. Management seem to be preparing for the sale by reclassifying Valitor as held for sale and announcing that marketing for Valitor will commence in 1Q19 with advice from Citi. A sale or spinoff of Valitor would have the following impact:

More detail on Valitor can be found in the Business section of this writeup.

More upside from reduction of risk weights and the Bank Levy?

There is potential further upside from the high risk-weight density of 67%, which is among the highest in Europe. A transition from standardized IRB to advanced IRB and reduction of risk-weights to something more in line with European peers could free up serious additional capital. For example, ISK 362bn of corporate loans are held with a risk-weight density off 100%, ISK 113bn of retail SME loans at 75% and ISK 349bn of mortgages at 36%. A more typical but still conservative level in the European context would be large corporates at 60%, 50% for SME loans and 15% for mortgages. Getting approval for a transition to advanced IRB models from regulators tends to take several years, but the process is already underway. Receiving approval to bring risk-weights more in line with European peers would cut risk-weighted assets almost in half, freeing up another +ISK 63bn for distributions to shareholders. Assuming Arion paid out half of this by 2023 IRR would rise to above 33%.

Finally, Iceland currently imposes a bank levy of 0.376% on total debt above ISK 50bn. This bank levy is not tax deductible and takes about ISK 0.8-0.9bn out of Arion’s earnings every year. While there is no certainty on this yet, it is likely that the bank levy will be reduced in 2020 and could further be reduced several years out.

I don’t think it’s necessary to make a reduction of risk weights or the bank levy one’s base case to do very well in Arion. At the same time, both would be a reasonable step for regulators and politicians to take now that the banking system has been de-risked. All of this hopefully goes to show that many good things can happen to shareholders in an extremely overcapitalized bank that has a leading position in an oligopolistic markets. The following section will give a brief overview over Arion’s segments.

Business

Arion is a leading Icelandic bank with a business mix across retail and corporate banking, investment banking, mortgages, payments, asset management and insurance solutions. Arion tends to be either #1 or #2 in most of its markets.

Retail Banking (50% of operating income, 38% of assets)

Mortgages in Iceland are CPI linked, giving them interesting inflation hedging properties. Inflation is currently on the rise in Iceland due to the slightly depreciating exchange rate, rising to 2.8% in March 2019 from a low of 1% in June 2016. The weighted average LTV on the mortgage book is 58.3%, with only 3.7% of the mortgage book having an LTV in excess of 100%. 1.8% of the mortgage book is impaired, but 90% of impaired mortgages have an LTV below 100%, meaning recovery prospects are good should the borrower default. If inflation reaches a level of 5% or higher, this could become a problem from a credit perspective for Arion. However, the current mild pickup in inflation should mainly help boost net interest income on mortgages without resulting in meaningful credit deterioration. Competition in the domestic mortgage market comes from pension funds. Since 2016 domestic pension funds have grown rapidly in the Icelandic mortgage market, keeping a lid on margin expansion and limiting growth opportunities for domestic banks.

Corporate Banking (14% of operating income, 19% of assets)

Arion operates a full service corporate bank across all major industry sectors with an emphasis on the largest companies in Iceland. Arion has ISK 434bn of lending to corporates outstanding, roughly two thirds of which is to large corporates, whereas the remaining third are SME loans. Arion is the third largest Icelandic bank in the corporate sector with ~21% market share of the market. Seafood and real estate and construction are the two largest sectors in the corporate loan book at ~20% and ~32%, respectively. Arion does not provide a breakdown between the real estate and construction book. Anecdotally it is largely tied to hotels and hotel redevelopments. At ~6% of total assets it is large but not large enough to impair the bank should tourism inflows fall abruptly. About 40% of the term loan book is denominated in foreign currency due to the large number of export oriented customers. These customers’ main source of income tend to be in USD or EUR, matching the currency of the loan. Asset quality trends have been positive but concentration in the real estate and seafood sectors need to be monitored and occasional issues with smaller credits should be expected.

Asset Management (9% of operating income, 5% of assets)

Arion is the leading player in the Icelandic asset management market through Arion Banki Asset Management and fully owned subsidiary Stefnir managing a combines ISK 971bn of AUM. This compares to a domestic market size of ISK 2.5trn of AUM. In 2018, Arion’s Asset Management Division had 86% of AUM across institutional and pension fund clients and 14% with high net worth clients. The asset mix is spread across fixed income (~54%), equities (~36%) with the remainder in alternatives and cash.

Investment Banking (5% of operating income, 1% of assets)

Arion operates a full service investment bank in Iceland. In capital markets Arion is the leading equities broker with ~25% of market turnover on Nasdaq Iceland as well as high teens market share in fixed income markets. In corporate finance Arion has managed the majority of Icelandic IPOs since 2011 and actively works with corporates to provide solutions. However one has to keep in mind that Iceland is a small market and in some years there will be no new IPOs. Currently the two biggest IPO’s in the pipeline consists of Arion’s two main competitors, Íslandsbanki  and Landsbankinn who are expected to come to market by end of 2020.

Insurance, Subsidiaries and Other Divisions (22% of Operating Income, 37% of assets)

The remainder of operating income is derived from Arion’s insurance subsidiaries, property holdings in Iceland, Treasury and Arion’s stake in Visa.

Vörður is the fourth largest insurance provider in Iceland.  Arion Banki acquired Vörður on 30 September 2016. Vörður is primarily active in P&C with a miniscule life insurance business. By product, compulsory motor insurance contributes about half of P&C premiums, property insurance makes up another 20%, with the remainder in accident and health, marine, other motor and general liability cover. Insurance contributes a negligible amount to overall results.

Valitor / Payments

Valitor is the largest payments company in Iceland. It provides two main services. Firstly, card acquiring services - offering e-commerce and card present merchant payment solutions through direct and partner channels. Revenue in card acquiring is 80% of total revenue for Valitor and is made up of processing volumes as well as terminal rental fees. In addition Valitor issues physical and virtual cards on behalf of banks and programme partners. This area accounts for the the remaining 20% of Valitor’s revenues.

Valitor is a group member of Visa and a principal member of MasterCard. An additional way to look at acquiring is by splitting it into partner and direct channels. In the direct channel Valitor services merchants directly with end-to-end e-commerce and gift card solutions.  In the partner channel Valitor operates as principal partner to fintech players in payments (e.g. Klarna, Paymentsense and Hyperwallet). Partners typically provide the front-end customer interface while Valitor provides the back end processing in acquiring and issuing.

In the issuing segment Valitor provides only partner solutions, for example working with Caxton FX and MasterCard to develop a new multi-currency wallet for the UK market. In acquiring, Valitor is competing against the likes of First Data and in issuing against Wirecard and FIS.

International accounts for over 70% of Valitor’s revenues and is growing faster than the domestic Icelandic segment at 30%. Primary markets are the UK as well as the Nordics. Internationally Valitor has been active in Europe since 2003.

Going forward the main focus at Valitor will be primarily on the SMB acquiring side. To this end, in April 2017, Valitor acquired International Payments Services Limited, a UK based company that specialises in providing a payment terminal (POS) gateway for pan European retailers. In June 2017, Valitor acquired Chip & PIN Solutions, a seller of POS terminal and acquiring services to small and medium size merchants.

Risks

Credit Risk

The main risk in investing in Arion Banki is credit risk. Currently nonperforming loans and chargeoffs are de-minimis due to a strong credit environment. Future losses are most likely to come from the corporate banking book, as the mortgage book has an LTV of 58%. An investor in Arion Banki is most likely to see an occasional bad quarter due to a default in the corporate book. This is mitigated by the fact that the corporate book is only 19% of total assets and relatively diversified. The following lists a few examples of recent credit issues in the corporate book.

United Silicon: Arion Banki was the primary lender to United Silicon, whose primary operations comprised a silicon production plant that ran into operating difficulties in 2017 and declared bankruptcy in January 2018 with Arion Banki as the primary lender transferring the assets of the company into a newly established subsidiary of the bank. The bank fully provisioned for equity (ISK 1.2bn) and bond investments related to the operation (ISK 0.7bn) and incurred provisions of ISK 3bn related to loan exposure during 2017. Arion Bank management intends to either find buyers for the new subsidiary in its current form or proceed with the necessary remedial action to bring the plant to an operational level and divest thereafter. Management believes that €6mn would be needed to make the plant operational, though expect investments in the next 12-18 months would be very low as they relate to environmental impact studies. Management’s preference is to dispose in its current form to a trade buyer.

Primera Air and WoW Air

Arion Bank recently experienced the bankruptcy of two airline creditors, Primera Air and WoW Air. Both are low-cost carriers with small fleets of less than ten planes. The Primera Air bankruptcy and exposure was thoroughly discussed during fourth quarter earnings. The bankruptcy of WoW is more recent. From WoW Air’s public disclosures it seems that Arion has ISK 400m of loans outstanding to WoW Air and owns a small portion of the bonds. Provisions for this will hit first quarter 2019 earnings but shouldn’t be large enough to have a material impact on the capital return story or 1Q19 earnings.

Wholesale Funding Risk

While Arion exhibits a high level of reliance on wholesale funding markets with a loan to deposit ratio of 170 this is not unusual in Nordic markets, where pension funds are a key channel for household savings. This results in structurally high loan deposit ratios. Additional funding in excess of core deposits is locked in through asset-liability matched covered bonds and RMBS. If Arion decided to pay out 30% of its capital tomorrow, the bank would be able to replace common equity with funding through covered bonds.

Icelandic Economy

Iceland’s economy has made a significant recovery over the last several years, mainly driven by a large increase in tourism. The number of tourist arrivals has grown fivefold since 2011 from 0.5 to 2.5m in 2018 which has in turn driven significant demand for hotels and other tourism related industries. This has helped Iceland turn a current account deficit into a current account surplus, stabilizing its currency. While tourists with an outdoor focus are becoming increasingly interested in Greenland in addition to Iceland, I would be surprised if this led to a sustained drop in tourism to Iceland. That being said, a reversal of tourism flows to Iceland is a meaningful risk for Arion, as it is a prominent lender to hotels and other tourism related businesses.

Change of Business Plan Risk

Investors like the capital return story. However, Arion’s long-standing CEO who turned around the bank just retired. If the new CEO decides to use excess capital for acquisitions or value destructive growth, this would be a negative

Conclusion

Arion is a highly overcapitalized bank. Typical European competitors have CET1 ratios of 12-13% and risk-weight densities less than half those of Arion, implying leverage ratios of 5-6%. Yet Arion produced a 6.6% ROE in 2017 due to a 23.6% CET1 ratio and 15.4% leverage ratio. Once Arion returns to more normal leverage/capitalization levels, it will be a far more profitable bank. Through the disposal of Valitor and further digital/mobile banking and cost cutting initiatives, Arion targets a cost to income ratio below 50%, a CET1 ratio of around 17% and an ROE above 10%. What this writeup has hopefully shown is that the targets set by management should be achievable solely through capital allocation decisions. In fact, paying out dividends to shareholders, buying back stock and finding a buyer for Valitor alone can get them there.

The base case IRR calculations are based on a conservative exit assumption of 0.86x book value, which is derived from an 8.6% ROE. This assumes static run-rate earnings of ISK 12bn. This is meant to illustrate how Arion shareholders can do well with highly conservative assumptions. As part of a highly oligopolistic market with limited competition, Arion should be able to earn 10%+ ROEs over time. The only reason they are not producing these numbers right now is the large amount of excess capital which they are fixing by returning capital to shareholders. One-off credit issues together with the ongoing forced selling from Kaupskil have created an attractive entry point.

While there are many optically cheaper banks in Europe based on price/book, none of them have a competitive position like Arion. They also tend to be undercapitalized. What makes the Arion situation unique is the combination of large amounts of excess capital, a clear intention to return it to shareholders and a strong competitive position. As a final note, Arion is listed in Iceland but also has a liquid Swedish Depositary Receipt that is traded in Stockholm. Accounts that can't access the Icelandic markets directly need to think about the additional ISK-SEK currency risk, which I believe is limited.

Catalysts

Disposal or Spinoff of Valitor

Issuance of AT1 and Tier 2 bonds to further accelerate capital return

End of forced selling by Kaupskil

Reduction of Iceland Bank Levy

[1] https://www.reuters.com/article/idUSL1046464620080110?view=sphere

[2] http://eng.forsaetisraduneyti.is/news-and-articles/nr/3033

Catalyst