Participations and fees assisting H119 results

UBK reported a 17.1% y-o-y increase in pre-tax profit to €21.6m, which is a positive surprise given management’s full year guidance of broadly stable pre-tax profit versus FY18 at c €37m. We estimate that the bank’s interest income remained largely unchanged vs H118, with incremental interest from new loans mostly offset by the additional interest expense associated with the new subordinated debt, some residual interest margin pressure (which we expect to diminish) and potentially also lower prepayment fees (given that last year UBK booked repayment fees on two sizeable loans).

Consequently, one of the key drivers behind the growth in the bottom line was stronger profits from UBK’s participation in renewable energy projects. In our opinion, these were assisted by exceptionally good wind conditions in H119, particularly in February and March (onshore wind energy output in Germany was up by 17.5% y-o-y according to the Federal Association of the Energy and Water Industries, BDEW). UBK holds equity interests in wind parks with a total capacity of 48.5MW (as at end-2018). Moreover, UBK booked commission income was up 64% y-o-y to €2.2m on the back of additional fees from corporate fixed income securities issues (such as the NATURSTROM issue announced earlier this year), in line with our forecast. Based on a discussion with the company, we understand that commission income was also assisted by growing distribution fees due to stronger customer demand for shares and investment funds.

New lending volumes reached a good level of €261m in H119, although this was 16.1% below last year’s (H118) €311m. Given that UBK’s new loans reached €123.4m in Q119 (compared with €106.0m in Q118), this implies new lending volumes in Q219 of c €138m (around 33% below the c €205m in Q218). That said, it is important to note that H118 (and Q218 in particular) was exceptionally strong, with new volumes more than doubling from €154m in H117. Hence, H119 volumes were nearly 70% higher than in H117. Furthermore, it is important to note that UBK’s quarterly lending volumes may be influenced by the funding of a few large projects and thus can be relatively volatile. According to the company, new lending in wind projects remained broadly in line with H118, which in our opinion is encouraging given the continued challenges facing the wind energy sector in Germany (see below). Overall, business volume expressed as total assets plus irrevocable lending commitments and contingent liabilities rose by 4.9% ytd. However, UBK’s loan book (including irrevocable lending commitments) increased by 1.3% ytd, suggesting some larger loan repayments during the period. Importantly, UBK’s customer base expanded by 1.2% y-o-y, with a significant contribution from clients in the ‘under 45’ age group (in line with UBK’s strategy).

UBK’s cost income ratio (CIR) reached 36.2% in H119 compared with 32.7% in FY18. This is broadly in line with our earlier FY19 forecast of 35.9%. Personnel expenses rose by 18.1% y-o-y to €5.3m as the bank continues to expand headcount (184 on average in H119 vs 163 at end-2018) to facilitate further business growth. This compares with our FY19e expectation of 18.6% y-o-y growth. Other administrative expenses in the period rose by 16.5% vs our FY19e forecast of 10.3%, although the difference is largely explained by the higher contributions to the Compensation Scheme of German Private Banks (up 36.8% y-o-y) following continued strong growth in customer deposits (which increased by 4.8% in H119 vs our FY19e growth assumption of 7.0% y-o-y). In conjunction with the lower effective tax rate (29.2% in H119 vs 32.7% in H118), this translated into a 23.1% y-o-y increase in net profit to €15.3m.

In line with its earlier intentions, UBK finalised its new share issue in July 2019, with around 2.38m new shares subscribed at a price of €9.90 per share (resulting in an 8% dilution, according to our estimates). As a result, the company raised €23.5m in gross proceeds. Initially, it planned to issue up to 3.5m shares and raise up to €35m of new capital. Hence, UBK raised c 67% of the maximum targeted proceeds. Still, we believe that UBK is now well equipped to expand its loan book in the coming years (see our capital ratios discussion below).The capital increase was structured as a rights offering, with one new share offered per every eight shares held by current shareholders. Shares not subscribed in the rights offering were offered to existing shareholders through a supplementary subscription and to other investors by means of a private placement at the same price of €9.90 per share.

The company will use new funds to strengthen its capital base and enhance business growth. Specifically, the issue will further improve UBK’s Tier 1 ratio, which as at end-June 2019 stood at 8.9% (vs 9.3% at end-2018). By raising the ratio, UBK hopes to allow for a reduction of the 1.5% special buffer added by the German regulator to its capital requirements. When adjusted for the share issue, UBK’s total regulatory capital was €362.3m at end-June 2019.

The roadblocks in new capacity development discussed in detail in our recent outlook note continue to constrain the wind market in Germany. According to Deutsche WindGuard, gross wind capacity additions reached a meagre 287MW in H119 vs c 5.4GW in 2018 (see Exhibit 3). At the same time, interest in new tendered wind capacity remains low, with only 42% of the capacity offered during the recent auction in May being allocated.

As we discussed in our previous note, the roadblocks include extended regulatory requirements, lengthy project approval timelines and a deficit of approved regional plans, as well as resistance from local residents and environmentalists. Initially, the German government was slow to address these issues, but it seems that pressure is increasing to unlock the wind development potential to reach the targets set in the Renewable Energy Act. This is illustrated by the demand for a wind energy summit issued by a group of Social Democratic Party members of the German parliament. Germany’s minister of economy has announced that the summit will be organised following the summer break.

On the contrary, solar development continues at a solid pace, with around 2.0GW of capacity added in H119 compared with 2.95GW in the whole 2018 (see Exhibit 4). The recent solar auction in June suggests further good progress, with allocated capacity of 205MW ahead of the originally offered 150MW. Interestingly, new large photovoltaic (PV) projects in Germany may reach grid parity (ie generate electricity at a cost below market prices) and become independent from government support schemes (such as the EEG) from 2020, according to the advisory institute Enervis.

The German residential market has seen a slight 2.4% y-o-y decline in building permits between January and May 2019, reflecting the cooling of the broader economy. Permits for single family houses rose by 2.3% y-o-y, while multi-family houses saw a 4.1% y-o-y decline.

Despite the weak wind sector and somewhat softer overall residential construction market, we believe that UBK’s niche expertise and relatively low size coupled with its strenghtened balance sheet should drive its market share and thus loan book growth. That said, a further deterioration in market conditions (especially in the wind segment) represents a potential downside risk to our investment thesis.

Although H119 pre-tax profit growth was visibly ahead of our FY19 assumptions, we keep our full year forecast broadly unchanged (see Exhibit 5). In line with management guidance, we expect improved earnings from participations as well as higher commission income posted in H119 should be largely offset by the one-off costs associated with the new share issue, as well as incremental costs incurred in conjunction with UBK’s strategy. After pencilling in the new share issue, we expect UBK’s Tier 1 ratio to be 12.1% at end-2019 (compared with the regulatory requirement of 9.6%) and its total capital ratio to stand at 15.4% (vs the regulatory requirement of 12.0%). We reduce our loan book growth expectations for FY19 given the modest H119 growth of 1.3% ytd, which we understand is a function of quite high loan repayments in the period. We currently assume loan book growth of 4.3% y-o-y in FY19e (vs 9.4% previously), while keeping our longer-term assumptions broadly unchanged.

We have also factored in the impact of the recent share issue on our forecasts and valuation. We have conservatively not included any incremental earnings which may be fuelled by the fresh equity capital, given that our previous forecasts already implied a certain level of balance sheet headroom. However, given that the share issue was conducted at a price that is ahead of UBK’s tangible book value per share (€8.7 according to our last forecasts for FY19e), this has translated into a minor positive impact on UBK’s valuation, which now stands at €13.2 per share.

We estimate a return on equity (ROE) for UBK in FY19e of 10.4%, which compares with an average ratio for listed banks from the DACH region at 9.0% (based on Refinitiv consensus). We note that UBK’s FY19e ratio is below our long-term sustainable ROE estimate of c 12.8% due to depressed net interest margin (which we expect to bottom out soon) and higher operating expenses amid the launch of new products. At the same time, UBK’s FY19e P/BV is 1.1x, which is broadly in line with the peer average (see Exhibit 6).