The Arion Bank IPO and what happens after?

On Thursday, 2 August 2018, Arion Bank will release its financial results for the first six months of 2018. This will be the first release of financial statements since Arion Bank completed the IPO of approximately 30% of its common shares in a secondary offering.

Background to the IPO

The Arion Bank IPO is interesting for a number of reasons:

  • Arion Bank is the restructured entity of what used to be the local bank operations of the infamous Kaupthing Bank, which went bankrupt during the financial crisis of 2009. Kaupthing Bank’s dubious fame derives amongst others, from the Kaupthing Edge deposit program and ads featuring John Cleese.
  • The Arion Bank IPO marks the first return of an Icelandic commercial bank to the stock market since the crisis.
  • Five months prior to the IPO, the Icelandic Government sold its 13% stake in Arion Bank to Kaupskil, the banks biggest shareholder, as Kaupskil exercised an option to purchase the Government’s stake in the Arion Bank.  The Government received some criticism at the time as the purchase price was under the stated book value of the Arion Bank equity and Kaupskil was thought to have acquired the stake on the cheep.
  • Prior to the exercise of the option for the 13% purchase of the Government’s stake, Arion Bank had agreed to buy 9.5% of its own outstanding shares from Kaupskil. The agreement was contingent on the purchase of the Government’s stake. Both transactions were priced at ISK 90.087 per Arion Bank share.
  • Kaupskil is, in fact, a subsidiary of Kaupthing Bank, which is still in receivership. The owners of Kaupskil are therefore the creditors of the bankrupt Kaupthing Bank along with distressed investors and vulture funds that entered the fray after Kaupthing went bust.
  • This is one of the biggest IPO in the history of Iceland and was specifically marketed in Sweden with the creation of a Swedish Depository Receipts (SDRs) that trade on the Swedish Stock Exchange. The creation of the SDR was primarily to increase the availability of Arion Bank shares to a broader base of investors outside of Iceland.
  • The IPO closed on June 15 with a final offer price for per each Arion Bank common shares set at ISK 75. This is a price considerably under the last stated book value of the common share. There are currently 1,810,000,000 shares outstanding (Arion Banki holds 190,000,000 treasury shares), each with a par value of ISK 1. Total shareholders equity under IFRS 9 was 226,548 million ISK at the end of 2017 or ISK 125.16, excluding treasury shares. At the current market price of around ISK 83, Arion is trading at roughly a 33% discount to book value.

Was the Arion Bank IPO a failure?

At first glance, the Arion Bank IPO does not seem to have made much sense. Why would Kaupskil as a majority shareholder buy the 13% stake off the Icelandic Government at roughly ISK 90 per share, then subsequently sell a 9.5% share back to Arion Bank, only to sell a substantial portion of its holding in an IPO priced at ISK 75 per share, five months later?

The answer is that it is hard to tell, really. Perhaps, within Kaupskil, the management thought that it ISK 90 per share was a fair price at the time and they were confident that they could get similar prices at the IPO. An IPO at this size in a market this small is a bit like trying to manoeuvre an aircraft carrier. Once you are on your way, it’s not very easy to turn around.

Apparently, Arion Bank had planned to list earlier but had delayed due to the difficult market environment. The creation of the SDR also shows the importance for the bank to extend the reach of the addressable market and to appeal to a broader investor base.

However, there is also a possibility that the IPO actually was a success. The key here is the intention of Kaupskil and the second largest shareholder, Taconic Capital Advisors. These are, as mentioned above, Kaupthing creditors and distressed investors who have bought those claims. Therefore, it can be safely assumed that the IPO is part of an exit strategy, possibly due to a lack of interest by potential strategic buyers.

As these two shareholders combined hold 42,67% of the issued capital (including the 9.5% held by Arion as treasury shares) after the IPO, it is imperative for them to create liquidity for the stock. One step to achieve this is to make the IPO as appealing as possible, most importantly by offering a very favourable price. In that sense, the IPO was a big success the offering was oversubscribed by many multiples.

What Can Shareholders of Arion Bank Expect?

In the first quarter of 2018 Arion Bank delivered an underwhelming 3.6% return on capital to its shareholders. This to some extent is the real reason for the shares of Arion Bank to trade under book value. But just as with the IPO, there is an alternative view to this.

Commercial banking in Iceland, as in many other European markets, is relatively saturated. The market is controlled by 3 big players an there is limited room to grow. Looking at the balance sheet of the Arion Bank it is quite apparent that the bank is amply funded. In fact, to many, Arion Bank is severely over-funded with a limited way of deploying that capital in the market. Common Equity Tier 1 (CAR 1) – a measure of a banks solvency and capital strength – at the end of 1Q2018 was 23.6%. This is an extremely high ratio compared to other European banks.

Valitor, Stefnir and Vörður

It is worth mentioning that in addition to its core banking operations, Arion Bank owns three main subsidiary companies. Vörður, an insurance company in Iceland and Stefnir, an asset management operation, have been sailing relatively steady course in recent years. Valitor, a Payment Service Provider, on the other hand, has been somewhat of a problem child.

Valitor is also a growth story and a company that has an addressable market outside of Iceland. Valitor provides payment services to clients across Europe and is currently providing acquiring services for various online operations, most notably Stripe. In a recent interview, Höskuldur Ólafsson, CEO of Arion Bank stated the intention of the bank of finding a strategic buyer of Valitor.

Capital Allocation Will be Key

To summarize the scenario, you have:

  • An over-capitalized bank, that has trouble to achieve satisfactory rates of return,
  • A big block of shareholders holding over 40% of the outstanding shares that is, looking for an exit.

Absent of opportunities to deploy capital to its lending portfolios it is hard to see another way of the management of Arion Bank to allocate capital to anything else than a large-scale return of capital to its shareholders. Seeing as there are divergent needs of the capital base, a buy-back program would make the most logical sense. This would allow the existing shareholders to exit in a tax efficient way without forcing shareholders across the line to accept capital returns. Lowering the capital base should at the same time improve the profitability of the banking operations.

A Simple Arion Bank Investment Thesis

In very simple terms, there are two main scenarios could play out at Arion Bank. If the bank were to improve its operating results, thus earning the required rate of return on its capital, that would be reflected in the market value of the shares, which could appreciate drastically.

A more likely scenario is that the bank will underperform in terms of return of capital until it has returned a significant amount of capital to its shareholders. In the meantime, it is to be expected that holders of a large block of shares will trim down their holding over time in the open market, which should keep a downward pressure on the share price. However, for a long-term shareholder of Arion, this could be a positive effect as that will allow Arion Bank to repurchase and retire shares at significantly depressed prices.

Hence, the simple thesis is that an investor with a time horizon extending over a few years should be able to reap benefits irrespective of the near-term price gyrations of the stock. That is, as long as the management of Arion Bank sticks to doing the obvious in terms of capital allocation.

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