Allied Irish Bank: Back to the future

[dropcap]W[/dropcap]e are initiating coverage of AIB with a Sell recommendation. All the valuation approaches point to a stretched valuation, while the visibility on the group’s operating environment has reduced sharply, notably (but not exclusively) because of the potential disruption of Brexit.

Refocused business model, duopolistic positions

Following several years of a forced diet, the new AIB has been refocused around a simple and largely domestic business (90% of revenues). Following the restructuring of the Irish banking market, the group’s duopolistic positions shared with its almost unique competitor, Bank of Ireland, have been strengthened further.

This provides some advantages in terms of pricing power but reduces risk diversification making the country prone to another great financial crisis. In such a context, we would not be surprised to see regulatory authorities promoting challenger banks in the coming years with the aim to encourage some competition.

Loan book growth resumption pivotal to mitigate the provision writebacks’ disappearance headwind

AIB targets a +10% RoTE by 2019 based on a 13% CET1 ratio. This corresponds to a reduction versus 2017 which enjoyed provision writebacks. Over the period, the cost of risk is expected to align progressively with the gross cost of risk which stands at around 35bp. Such a headwind is expected to be mitigated by positive operating jaws with the cost to income ratio decreasing by 2ppt.

These positive jaws will be driven by the progressive resumption of loan book expansion (+6.6% over the period). The increase in operating costs will be mitigated by the reduction/reallocation of 50% of the 1,500 staff dedicated to NPL restructuring.

Fundamental valuation largely reliant on the across-the-cycle cost of risk assumption

AIB shows a particularly elevated net interest margin (3.6% of performing loans when adjusted for interest income accrued on impaired loans) be it by domestic and above all European standards.

Even if this can be partly explained by dominant domestic market positions, we suspect it largely reflects a higher-than-average sustainable cost of risk as evidenced by the group’s 1.3% past 20 years average. As far as we are concerned, we consider that an 80bp across-the-cycle cost of risk is more consistent with a 3.6% NIM.

Questionable excess equity value

AIB enjoys a high CET1 ratio largely in excess of its 13% objective and the continuation of a benign cost of risk will translate into further “excess” equity accumulation while management intends to increase the payout ratio from the current 30% to above 50% only progressively.

As far as we are concerned, we do not pay too much attention to capital distribution as, according to Modigliani and Miller, it is neutral on the valuation.

However, for those with a different view, it is worth noting that the availability of such an “excess” equity remains largely reliant on the decision of the regulator, not to mention the State which still holds more than 70% of the capital.

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