Aareal Bank AG (OTCPK:AAALF) Q3 2022 Results Conference Call November 10, 2022 5:00 AM ET
Company Participants
Jürgen Junginger – Head of Investor Relations
Jochen Klösges – Chief Executive Officer
Marc Hess – Chief Financial Officer
Conference Call Participants
Johannes Thormann – HSBC
Jürgen Junginger
Good morning, everybody. I’m pleased to welcome you to our today’s conference call. In our today’s agenda, we’ll cover the results of the Third Quarter in the First Nine Months and also the outlook of the rest of the year.
I’m joined by our CEO, Jochen Klösges; and our CFO, Marc Hess, who will be happy to take later questions and giving you hopefully the right answers to them.
I’m pleased now to hand over to Jochen. The floor is yours.
Jochen Klösges
Thanks, Jurgen. Ladies and gentlemen, good morning, everybody. I would also like to welcome you to today’s conference call. My colleague, Marc Hess and I will review Aareal Bank Group’s third quarter performance today and update you on how we view the current situation of our business.
Let us take a look at the key points first. You see we have continued our strong operating performance in the third quarter and achieved a good result, despite a further provision on our remaining exposure to Russia. Operating profit of €66 million was both above the previous quarter and also above the last year’s third quarter.
This was despite recognizing a further loss allowance of €43 million on Russia. Excluding this charge, operating profit would have risen to more than €100 million, which shows how strong our operating profitability has become. The addition to the loss allowance on Russia was due to further deterioration in the outlook on the war in Ukraine. Even though our Russian borrower continues to be willing and able to pay, the exposure still cannot be serviced due to the sanctions imposed by Russia.
Excluding Russia, the loss allowance in the third quarter was only €20 million. Russia also dominates this income statement line on a nine-month view, accounting for approximately 3/4 of the total. This also means that there were hardly any defaults in the remaining portfolio, and hence, little direct impact from the deteriorating macroeconomic situation so far.
We see this as a sign of the high quality of our loan book and continuing normalization following the pandemic. We are also very pleased to see that our strong earnings momentum continues with net interest income rising by 19% year-on-year in the third quarter to reach the highest level in seven years.
Net commission income increased by 20%, driven particularly by Aareal’s continued growth. We therefore see that our strategy is bearing fruits. We are exploiting opportunities for profitable growth in all segments, while being more risk conscious due to the current macroeconomic environment.
And of course, we also remain vigilant on costs. Our strategy of controlled growth at low marginal costs is working. To put it in simple terms, we are generating more business from the same machines.
All in all, it is worth the effort. For example, we further reduced the cost/income ratio in the banking business to 39% in the third quarter, a truly impressive figure. While this development is obviously due to higher earnings, we are keeping a firm hand on our cost base so that we are also prepared for the future.
The current environment is challenging. However, we also report good news on the funding front. We completely — we completed our full year capital market funding plan by the end of the third quarter, this despite stronger than planned growth in lending volume, and this makes us less dependent on developments in the highly volatile capital markets over the coming months.
Aareal Bank also continues to have a very solid capital base. Our CET1 ratio of 19.4% is at a very high level, which leaves us well prepared if economic conditions become more adverse. Our operating profit outlook for the current financial year remains unchanged. We still assume that we will achieve the lower end of the €210 million to €250 million range. This is despite the considerable strain imposed by our exposure to Russia, transaction costs from the takeover by Atlantic BidCo, and the impact of the ECB’s TLTRO decision.
Of course, we hedged our TLTRO funding, and must now unwind this position following the ECB’s amendment of the terms. This will have a negative effect on fourth quarter earnings. However, the important fact that remains is, we can stick to our outlook despite these unforeseen burdens.
This again shows the strength of our operating business. It goes without saying that in the current environment, our outlook for the full year must be subject to the [proviso] that the direct and indirect impact of the war in Ukraine remains very difficult to estimate. And just a brief mention of the takeover by Atlantic BidCo.
The investors continue to expect completion of the qualifying holding procedure during the first month of the new year. So at this point, I would like to hand over to Marc, who will guide you through the key financial indicators for the third quarter and the first nine months of the year. Over to you, Marc.
Marc Hess
Yes. Thank you, Jochen, and good morning to everyone. As you just said, Jochen, we are consistently implementing our strategy, and we are delivering tangible results, as you can see here on Page 4.In particular, our strong operating performance in the third quarter allowed us to offset the significant additional risk provision on our remaining exposure in Russia. Our performance is based on two strengths.
One is the income that we are growing dynamically, and second, the costs that are only growing modestly, and is what we call growth at low marginal costs when we published our new strategy back in January 2021.Our new — our net interest income reached €184 million, which is a 19% — unfortunately, only 19% increase compared to the third quarter of last year.
Net commission income rose by 20% to €67 million over the same period. And we kept our costs under tight control compared to the previous year’s third quarter costs, rose only slightly by 2%, and this increase was exclusively driven by Aareon’s acquisition and those related expenses. Thanks to our strict cost discipline, expenses at the bank were even slightly down on a like-for-like basis. That means we have fully delivered on the promises we made when we presented our revised strategy at the beginning of ’21.
Thus, we are able to increase operating profit by 32% to €66 million in the third quarter, despite the additional risk provisions of our remaining exposure to Russia. Therefore, we are very happy with the operating performance so far this year. So let’s look at the details on the following slides and start with the positive earnings performance. Let’s just mention that interest income amounted to €184 million in the third quarter, and as Jochen has said, this is the highest quarterly figure we have achieved in seven years.
In a nine-month comparison, that translates to a year-on-year increase of 18%. Even so, the previous year was already up significantly. Main reason for this increase are larger credit portfolio and the diversification of our funding mix. In addition, we are seeing the first positive effects from high interest rates in our deposit-taking business, and Jochen will explain this further in a moment.
Net commission income showed a remarkable increase of 14% over the first nine months, reaching a total of €199 million. This rise reflects an increase in sales revenues at Aareon, which continues to grow strongly, both organically and through acquisitions. Our BDS segment also contributed to the rise in net interest — net commission income, the transformation of Aareon to a company with a business model that is based on Software-as-a-Service, and then subscription continues to progress well.
In this context, the SaaS business grew by more than 20% during the first nine months, stronger than Aareon’s overall revenue growth. At the same time — and you can see that on the next slide, we have continued to work on our cost efficiency. First nine months of the year the admin expenses totaled €423 million. This includes the one-off impact of around €12 million for transaction costs resulting from the takeover offer by Atlantic BidCo booked in the second quarter. In fact, adjusted for this one-off, we even managed a slight reduction in the bank’s cost compared to the nine-month period last year. That we were able to do this despite the significant growth of the business, demonstrates our strong cost discipline and the strict implementation of our efficiency measures.
Cost/income ratio for the banking business improved to 39% after the first nine months, and was therefore, 11 percentage points lower than the previous year. Thus, we not only reached our 44% target one year ahead of schedule, but also ranked amongst the best banks in Europe. Risk provisions for the third quarter rose by €24 million year-on-year to €63 million. As Jochen has already mentioned, risk provisions are dominated by the €43 million provision on our remaining exposure in Russia and reflects the deteriorating prospects of the rapid de-escalation in the Ukraine, unfortunately.
For the first nine months, the risk provisions amounted to a total of €170 million. At €126 million, which is 3/4 of the total, the provisions for Russia now equate to about 60% of our Russian exposure. Net exposure is plus around 70% below the last appraisal value, which was in October of 2021 before the war. Excluding Russia, risk provisions amounted to only €44 million in the first nine months. That demonstrates the high quality of the loan book and strong recovery from the COVID pandemic. This can also be seen in the NPLson the next slide. The recovery is reflected here. It continued to improve and reached 4.3% at the end of October.
In the third quarter, there was only one new nonperforming loan, and this one was related to an office building in New York. Overall, NPL volume has fallen by almost €200 million since the start of this year to €1.39 billion, and this is despite the addition of around €200 million from our remaining Russian exposure. Otherwise, we would have been down significantly by €400 million. What is, I think, especially remarkable is that the hotel share of the NPL has shrunk from 1/3 at the start of this year to around 10% now. This demonstrates again the significant recovery that has occurred since COVID-19.And now back to you, Jochen.
Jochen Klösges
Thanks, Marc. Yes, let’s now turn to our three business lines, and first start with structured property financing. As I mentioned initially, we are growing in a controlled manner and keeping an eye on potential risks. This means that we are expanding our lending volume but not at any cost. We are maintaining our conservative percentage, and that’s very important. So let me put this into figures, please.
We generated just under €7 billion of new business in the first nine months and around €1.7 billion of that was in the third quarter. That’s roughly €1 billion more than in the same period last year. Average loan-to-value ratios of the newly acquired business remained very conservative at 57% for the first nine months, and are even better at 55% in the third quarter. Our gross margins averaging 227 basis points continued to be very good and above our target. The business remains highly diversified by region and sector with logistics, properties accounting for the largest share in the last month. This asset class, which is attractive to us, is growing even though margins are lower compared to other asset classes. We continue to pursue our sustainability agenda, both in new business and in our existing portfolio.
We issued new green financings of approximately €600 million in the first nine months of the year and another set of already issued financing amounting to around €800 million reclassified as green financing. These loans are for buildings that meet our green criteria where clients have now contractually undertaken to provide evidence throughout the lifetime of the contract. And it’s all, of course, in accordance with our externally certified green finance framework.
Strong new business this year has further increased our portfolio volume to €31.9 billion as of 30th September, 2022. This means that we have significantly overachieved our target. Obtaining business, of course, dependent on market conditions and strictly adhering to unchanged conservative risk standards. We will continue along this path taking advantage of attractive opportunities when they arise, and we remain convinced that they will materialize.
Despite the weakening economic momentum in many economies and the risk of recession, we continue to see good opportunities. Aareal Bank is well diversified in terms of regions, and has very experienced sector specialists in its relevant markets and asset classes. As you can see in the lower left corner of the chart, we generate around 90% of our business in this segment outside Germany.
1/3 is generated in North America, a region where, we believe, that reactions to economic events in upturns as well as in downturns, are more flexible and faster than in Europe. This geographic diversification is therefore important to add to our business as we meet the challenges that lie ahead. After all, experience shows that North America is usually already on a recovery path on the crisis in Europe. That is a help in terms of diversification of risk. Also, it is important to note that we do not finance developments. We only finance completed properties which sometimes will be refurbished and upgraded, for example, to meet ESG requirements. We made this decision quite some time ago, and it makes sense.
It is important in today’s environment since we are not affected at all by new projects that have been now launched, and are currently more exposed to the changing environment. Ladies and gentlemen, as I have already mentioned, the key indicators are relevant for the quality of the loan book, are satisfactory across the board. The average loan-to-value ratio has improved further and is now at 57%, while the yield on debt has gone up further. Both indicators have largely returned to pre-pandemic levels. LTVs in the hotel and retail asset classes which were particularly affected by the pandemic, are now well below the 60% mark. Both asset classes also have also contributed significantly to improving the yield on debt on a portfolio basis. These two sectors have survived the ultimate Corona stress test. Today, we know that we were right not only to support our clients, but to expand then to expand the business on a selective basis where many market participants no longer believed in the hotels and retail sectors. The green office trend is partly responsible for yield on debt, not yet reaching pre-COVID levels in office.
In other words, for properties to become greener, offices have to be renovated to improve their energy efficiency. Often, that means that tenants can use their offices only to a limited extent or not at all, until the measures have been completed, which goes hand-in-hand with temporary rent declines. But financing the transformation towards more green buildings is really a key element of our strategy for the property finance business. So let’s turn to Banking & Digital Solutions where we’re also making very good progress. Net commission income increased by 15% during the first nine months of the year. Deposit volumes reached a new high of €13.5 billion, as already Marc mentioned, and thus, clearly exceeded the initially targeted level of roughly €12 billion for the year-end.
We have repeatedly emphasized how important deposits are for us as an additional funding source for our growing financing business. This is why we consciously accepted the associated negatives, while interest rates were low. As we all know, the wind has changed. The interest rate turnaround has, in fact, materialized, and it has also become visible in our income statement. The first positive effects have already made themselves felt in the third quarter, with net interest income for our BDS segment reaching €26 million. Now let’s turn to Aareon. Aareon is also making good progress in creating its sales revenue by 14% in the first nine months, despite its ambitious switch from the licensing business model to one based upon software-as-a-service for subscriptions.
Recurring revenues grew by around 20% in the first nine months of 2022 over the same period ended previous year. SaaS revenues increased by 24%. The share of Aareon’s overall recurring sales revenue increased to more than 70%. Our plan is to keep it clearly above this level in the future. Whilst Digital Solutions were the main sales revenue drivergrowing by 22%, ERP products also showed double-digit growth. Aareon’s adjusted EBITDA rose by 12% year-on-year.
The Company continues to be in investment — in an investment phase. Nevertheless, the margin was roughly stable at 21%.Aareon’s new management team is focusing on implementing the growth plan and increasing product portfolio efficiency. We affirm our medium-term targets of developing Aareon into a Rule of 40 software companies. Marc Hess will now take you through our capital position and funding activities as well as our outlook.
Over to you, Marc.
Marc Hess
Yes. Thank you, Jochen. By the end of the third quarter, we had already fully implemented our funding plan for the whole year. The pie chart on the left of this Page 17 here demonstrates that the board — or demonstrates the broad diversification of our funding mix. Still, one of our strategic goals remains to further diversify this mix.
And in this context, we have launched various initiatives in the past few months. So we launched, for example, a cooperation with Raisin and Deutsche Bank in June, which has progressed very well. In addition, our fixed income products have been made available on the Weltsparen investment platform recently, and the deposit volume generated on both platforms since their launch amounts to a total of around €270 million at the end of October. So we are progressing as planned, and yes, we are positive to reach our target of €400 million by the end of the year.
Our commercial paper program was initiated at the end of last year, and it’s also developing very well. It comprises both conventional and green formats which are denominated in our three main currencies: euro, sterling, and the U.S. dollar, and the volume that has been issued under this program today amounts to around €800 million. The new issue rating which we have obtained from Moody’s, a good A3, is also helping us to attract new investors.
And in the first nine months, we first placed funding instruments totaling €4.5 billion on the capital markets. This includes six benchmark transactions. We also raised a total of €1.3 billion in senior unsecured funding, including two green senior preferred issues of €500 million each. Private placements have clearly recovered as well to more than €800 million placed in the first nine months of this year.
On capital, on the next slide, you can see that our capital ratios remain at a very comfortable level. They provide a strong foundation for what might become a more challenging environment. Despite expansion of the lending business, we managed to increase the CET1 Basel 4 phase-in ratio by 1.2 percentage points to 19.4% during the course of the year. One of the supporting factors is in this context that we have fully retained the previously set aside dividends.
And another factor supporting our ratios are the risk-weighted assets, which we showed below-average increase compared to the growth of the lending portfolio. This is attributable, among other things, to significantly improved portfolio quality. So now let’s turn to the outlook. Despite some negatives, not foreseeable earlier in the year, we are maintaining our operating profit target. Thanks to our strong operating performance, we have once again adjusted the target range for net interest income upwards. We are confirming our guidance for risk provisions, but are now expecting to reach the upper end of the range due to the additional provisions on our exposure to Russia that we made in the third quarter.
In total, we will be able to offset three adverse factors that were not foreseeable when our outlook was presented back in February: First, the transaction costs associated with the Atlantic Bid takeover; second, the significant write-downs of our exposure to Russia; and third, the impact of the ECB’s TLTRO decision that we are expecting in the fourth quarter. As you know, at the end of October, the ECB announced an [unilateral] change to the contractual terms of the TLTRO as of November.
Like other banks, we had managed our interest rate change risk based on the prevailing terms by entering into hedge derivatives. As a CRE lender, it is not part of our business model to leave market price risks unhedged. So this is a standard procedure. Now that the ECB has unilaterally amended the conditions, these derivatives no longer have any underlying transactions and must, therefore, be closed out. This is what we have already done. We expect this to result in a valuation loss in the fourth quarter in the low to mid double-digit million euro range. But nonetheless, I just mentioned that, and I would like to emphasize this again due to our operational strength that still allows us to confirm our operating profit outlook for the full year.
So on that positive note, I would like to hand back to Jochen.
Jochen Klösges
Thanks, Marc. Yes, ladies and gentlemen, let me conclude by summarizing. We are all aware of the difficult economic environments and the major uncertainties clouding political and economic developments ahead. Nevertheless, at Aareal Bank Group, we feel well prepared even if times get harder. This is because our financials are sound, and because we benefit from strong relationships with our clients, which have grown over time and over years, and mainly because our strategy is clearly bearing fruit. By consistently implementing it, we have sustainably strengthened the bank’s operating profitability.
The encouraging operating performance for the year-to-date clearly shows that. As a result, we have been able to deal with the negative impacts from our remaining exposure to Russia, the transaction costs incurred by the takeover, and the ECB’s TLTRO decision, and still maintain our earnings targets. Despite all the challenges and uncertainties, we are therefore, looking to the future with confidence. And now we look forward to answering your questions.
Thank you very much.
Question-and-Answer Session
Operator
[Operator Instructions] The first question comes from the line of Johannes Thormann from HSBC.
Johannes Thormann
Three questions, please. First of all, on your LLP guidance of €180 million unchanged. Just taking up some numbers, do you expect very little cost of risk in the fourth quarter, although you haven’t fully impaired your Russian portfolio? And can you elaborate a bit more on this and probably explain why cost of risk should basically fall down to less than, yes, 20% of the previous quarters? First question. Secondly, on your NPLs, could you elaborate a bit more what has happened with the exposure in New York?
What was the problem there? And did you see how new NPLs are forming? And then what is probably also in the watch list?And last but not least, also on the NPLs, what are your expectations? Do you expect an uptick next year due to the deteriorating macroeconomic environment? Or do you expect still a continued rundown of your NPL portfolio?
And that was my second question. And the third question is just on Aareon. Yes, it looks like it’s growing, but the growth is always slowing down. And therefore, I’m struggling to see how you can reach your revenue targets with 22% to 25% CAGR in the next years? We probably have 20% this year. And then what is happening there?
Marc Hess
Yes. So on loan loss provisions, you’re absolutely right. Let’s say, comparing the upper end of our LLP guidance with what has been already booked after nine months, there is a comparatively low number to be expected for the fourth quarter. That is our current expectation. We said that’s a fraction of what we had before. Well, as we’ve stated, if one excludes Russia, we only had €44 million in the first nine months, or €20 million in the third quarter.
So having, let’s say, some €10 million for the fourth quarter as a reserve, it seems to be low, but not as low, if you extract Russia. And as of today, this is our best outlook. We also see some reversals coming up. So we are confident that we can be there. And we believe that with a write-down of 60% of the Russian exposure, we are quite where we want to be. Of course, it’s a very volatile environment.
And typically, Q4 is longer than all the other quarters until we close our books in early February. So there is always uncertainty. But so far, we are confident on this one. Your second question was on NPLs, one regarding the hotel — sorry, the office in U.S. This is not a great concern for us. Risk provisions associated were comparatively low because the appraisal values were very good.
So this, let’s say, NPL classification is a very technical function, if you have a reach of certain limits, so here in this regard, a [DSCR] decrease. So therefore, this is nothing really we are worried about. And regarding further NPL reduction, as I mentioned it, we are well on track this year to recover from these spikes that we have seen in the COVID pandemic. And obviously, the reduction would have been more pronounced if Russia wouldn’t have happened. Of course, it has. But yes, your assumption is correct that we still expect an ongoing — I would even say this decrease of the NPL portfolio going ahead over the next coming years.
Jochen Klösges
Yes, and then expand to that, let me answer the question referring to Aareon. Yes. So I already mentioned, I guess, last year that Aareon is obviously still in a phase where we will foster the business, invest into Aareon. And I must say, taking into account the current harsh environment — and obviously, this is also true for the software industry. Take a look at the various stock prices of peers of how they developed over the course of that year.
Then you can see, of course, that also software industry has to cope with this changing environment. But again, year-on-year, we now see a growth of 14% in sales and EBITDA adjusted also plus 12%. And even more important, the switch from license to SaaS business, and therefore, to more subscription, and therefore, increasing the share of recurring revenues, that’s been very important KPI, from my point of view, and we made good progress in all these areas. So I am really happy so far with the development this year with Aareon. We saw a significant increase in sales. EBITDA margin is okay. We speak to our goal to develop Aareon to a Rule of 40 company.
If you take into account, it’s obviously only a snapshot, but if you add to the 14% of sales revenue growth, the roughly 21 points of EBITDA margin, then you come up to 35%. That means we are on our way to reach the Rule of 40 targets with Aareon, and that’s driving our activities there.
Operator
[Operator Instructions] The next question comes from [Tim Adums] from DZ Bank.
Unidentified Analyst
I have one clarification, and I have also a couple of questions, please. So starting with clarification on your confirmed loan loss provisioning guidance. So I mean, this leaves basically €10 million net for the last quarter this year. So what should we expect here to be on the safe side so there should be no meaningful increases coming in neither from Russia nor for the remaining exposure? This would be my question number one, please. And then I spotted that the CET1 ratio went down compared with the previous quarter by 40 basis points.
Could you give us the drivers over there? This was related to lending — to increase in the lending portfolio. This would be helpful. And then maybe because we already touched briefly on the outlook for next year, maybe you could share with us your thoughts for 2023. So is it fair to assume another boost for NII and also post-pandemic push on NCI as well? And yes, how should we think about costs and loan loss provisions as well?
Marc Hess
First of all on LLP, your clarification question. Yes, as I just said, as of what we know by now, so being, let’s say, mid-November, we expect low LLP for the fourth quarter around €10 million, including some reversals that we may see. And that means, as you said, no meaningful increases currently on our radar. This is obviously a very volatile environment, as I just said, but it’s the best view that we have now. And we feel that with a 60% reduction in Russia and where we currently stand, we feel well provisioned. On the CET1, you have seen we had some increase in the [RWA], of course, related to the portfolio growth that we had seen in the third quarter. And we had also done some prudential provisions for some of our loans as a reduction in the capital.
Against that, of course, we have the retained earnings of the fourth quarter. So that in all — that all in all led to the slightly reduced CET1 ratio, which is obviously still at a very good level. And as you can see, much above where we started at the beginning of the year, despite of the fact that we had a significant growth in the loan book. For the outlook for next year, I would really like to ask you to be patient. It’s a good tradition for a good reason that we always, let’s say, give you the outlook in our annual press conference, which will be, I think, 2nd of March next year?
Jochen Klösges
Yes.
Marc Hess
Here, of course, we are — and that’s the reason why we don’t do it today. We are in the midst of our planning process, and we first would like to finalize this one before we give you an outlook.
Operator
There no further question at this time. I hand back to Marc Hess for closing comments.
Marc Hess
Yes. Thank you very much, first of all, for participating and for your questions. You are certainly aware that we will be available for one-on-ones in the following fixed income roadshow that we are currently setting up. And of course, also the IR team is available for further questions if they arise. So thank you very much, and have a very good day. Bye-bye.
Operator
Ladies and gentlemen, the conference is now over. And you may now disconnect your lines. Thank you for joining, and have a pleasant day. Goodbye.
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