2023-07-17 18:37:10 ET
Summary
- Based on a Residual Income Valuation, I have determined a stock price target of $89.62, assuming UBS successfully completes its integration with Credit Suisse within the expected timeframe.
- However, there is a significant risk that UBS may struggle to execute its plan within five years, primarily due to the limited time left for conducting the due-diligence.
- Therefore, I do not recommend initiating a long position on UBS before its Q2 earnings release. There is a possibility that their outlook may be revised downwards.
Thesis
UBS Group AG ( UBS ) may have made a groundbreaking deal by acquiring one of the world's largest banks for a mere $3.4 billion. However, the integration process poses several near-term obstacles. Among these risks, the primary concerns are the potential for UBS to delay the plan, which is set to conclude in 2027, and the risk of government intervention to impede the significant layoffs that are anticipated.
Based on a Residual Income valuation model, my projection suggests a target price of $89.62, representing a remarkable 328% increase from the current stock price of $20.91. It is important to note that this projection represents the most optimistic scenario. Nevertheless, it is crucial to recognize that UBS is still in the early stages of the integration process. Therefore, I do not recommend purchasing the stock prior to its August 31 earnings release, and suggest maintaining a "hold" rating until further information becomes available.
Overview
Since UBS's takeover of Credit Suisse, which, in my opinion, is a significant long-term catalyst, several developments have taken place. UBS discovered a mutual fund in China held in a joint venture with ICBC, which they decided to maintain. UBS expressed their intention to avoid utilizing the $10 billion backstop from the Swiss Government in case of winding-down losses associated with non-core business assets. Additionally, in Q2, they are expected to make a decision regarding the retention of Credit Suisse's domestic bank in Switzerland, which was one of the bank's most valuable segments.
This last decision holds great importance for me since the domestic bank could serve as a crucial earnings catalyst for UBS. It is expected to benefit from increased interest debt, the resilience of Swiss consumers, and their purchasing power. Furthermore, consolidating operations will automatically reduce costs as UBS and Credit Suisse branches in close proximity can be closed. However, this move puts 10,000 jobs at risk. To gain political favor, the government might broker a deal for this segment with a bank that does not operate in Switzerland. If the branches are sold to Raiffeisen Bank International, AG ( RAIFF ), or the Cantonal Banks, it would result in job losses.
The merger faces several challenges, but the most pressing one is the risk that if UBS doesn't act swiftly, Credit Suisse could create a hole in UBS's balance sheet. Moreover, deposits have not yet returned to Credit Suisse, which experienced a decline of approximately $74.3 billion when it reported its Q1 earnings on April 24. This leaves UBS to carry the burden of Credit Suisse's short-term debt.
To clarify, the deal is excellent, but in the short term, UBS may experience earnings setbacks and lower guidance. Therefore, it would be prudent to avoid investing in UBS until its earnings are released, and then consider buying it.
Financials (In millions of USD unless stated otherwise)
Currently, UBS is not the "king of profitability," as it has a negative Free Cash Flow margin. However, if we look at the average from 2018 to 2023, the FCF margin averaged 5.71%.
The main reason for this negative free cash flow is the Cash Flow from operations, which is currently at -$37.7 billion. This component has been the most volatile within the Free Cash Flow, while other components such as Interest expenses, taxes, and CapEx have remained relatively stable.
In terms of operations, the net interest margin has been decreasing and is now at 39.39%, down from 67.29% in 2021, reaching pre-rate hike levels.
On the other hand, UBS's non-interest income comes primarily from its extensive wealth management and investment banking operations. These operations contribute to 81.5% of UBS's revenue, which amounted to around $33.3 billion in 2023. This makes UBS highly exposed to market performance, as its fees decline when the market experiences a downturn, leading to a decrease in assets under management [AUM]. This reliance on market performance diminishes the possibility of UBS surpassing earnings estimates solely through increased interest income resulting from rate hikes. Additionally, UBS's commercial banking operations are predominantly focused on Switzerland.
Interest Income | Interest Expenses | Total Non-Interest Income | Net Income | Net Interest Margin % | |
2017 | $12,703 | $6,632 | $23,651 | $969.00 | 47.79% |
2018 | $12,796 | $7,748 | $25,573 | $4,516.00 | 39.45% |
2019 | $11,695 | $7,194 | $24,504 | $4,304.00 | 38.49% |
2020 | $10,109 | $4,247 | $27,218 | $6,557.00 | 57.99% |
2021 | $9,964 | $3,259 | $28,760 | $7,457.00 | 67.29% |
2022 | $13,185 | $6,564 | $27,823 | $7,630.00 | 50.22% |
2023 | $15,835 | $9,597 | $27,569 | $6,523.00 | 39.39% |
UBS's debt has not undergone significant changes in recent years, remaining relatively flat. The company also holds cash and short-term equivalents totaling $301 billion, which will nearly double after the acquisition of Credit Suisse.
Overall, UBS does not boast incredible profitability margins, although it has successfully reduced its debt. However, the acquisition of Credit Suisse will increase its debt, particularly considering that most of Credit Suisse's short-term debt stems from the $74.3 billion outflow the bank experienced during the recent banking crisis. This acquisition carries both significant potential for success and the risk of failure, despite being a bargain.
Valuation (In millions of USD unless stated otherwise)
To conduct this valuation, I will assume that UBS will not retain Credit Suisse's domestic bank. I will also attempt to predict the earnings from Credit Suisse's investment banking segment, which UBS has indicated will be "de-risked" and likely downsized. The following graph illustrates the expected structure of the combined entity when earnings come out in Q2:
As depicted, the new UBS appears to be in better shape, with increased free cash flow and improved margins. However that is just the immediate effect, UBS's plan to wind down Credit Suisse is estimated to reduce Credit Suisse's balance sheet by 20-40%. Consequently, Credit Suisse's revenue is expected to decline by 20%, and a total of 35,000 jobs will be eliminated within the combined entity between 2023 and 2027.
To begin, I need to forecast the Operating Income. I utilized a proportion of 44%, indicating that operating income represents 44% of the revenue after combining the revenues and operating incomes of both entities. Additionally, I factored in the anticipated cost savings resulting from the substantial layoffs. Based on my projection, UBS would need to dismiss approximately 7,000 employees annually over a five-year period to achieve the target of 35,000 job cuts. Furthermore, I estimated a 20% reduction in Credit Suisse's revenue, equivalent to approximately $860 million per year for five years. The table below presents all these variables:
UBS | Credit Suisse | Total | Operating Income | Plus Cuts in Expenses | |
2023 | 33,758.0 | 25,821.5 | 59,579.5 | 26214.98 | 27604.98 |
2024 | 33,758.0 | 24,961.5 | 58,719.5 | 25836.58 | 28617.58 |
2025 | 33,758.0 | 24,101.5 | 57,859.5 | 25458.18 | 29630.18 |
2026 | 33,758.0 | 23,241.5 | 56,999.5 | 25079.78 | 30643.38 |
2027 | 33,758.0 | 22,381.5 | 56,139.5 | 24701.38 | 31655.88 |
2028 | 33,758.0 | 21,521.5 | 55,279.5 | 24322.98 | 31277.48 |
Another aspect requiring prediction is the book value. I assumed a figure of 40% for Credit Suisse's balance sheet reduction, which equates to an asset sale of $3.9 billion annually over five years to achieve a 40% reduction. UBS's book value has increased by approximately 0.7% annually since 2013, so I left it unchanged.
UBS | Credit Suisse | Total | |
2023 | 57,106.0 | 55,354.0 | 112,460.0 |
2024 | 57,106.0 | 51,401.0 | 108,507.0 |
2025 | 57,106.0 | 47,448.0 | 104,554.0 |
2026 | 57,106.0 | 43,495.0 | 100,601.0 |
2027 | 57,106.0 | 39,542.0 | 96,648.0 |
2028 | 57,106.0 | 35,589.0 | 92,695.0 |
Finally, the predictions for net operating assets are also expressed as a proportion based on the book value. Net operating assets represent 3.6% of the book value, and I projected them accordingly. The following graph displays the Residual Earnings Valuation table incorporating all of these variables:
According to the model, the price target for this new entity is $89.62, which represents a 328% increase from the current stock price of $20.91. However, there are several factors to consider. UBS would need to act swiftly and adhere to its plans without delay to achieve this target. In the event of a recession, UBS may witness a decrease in assets under management [AUM] in its wealth management division, resulting in reduced revenues. A recession could potentially halt the plans for 1-2 years. Additionally, the challenge of carrying out such massive layoffs without drawing government complaints, particularly in Switzerland, where it is estimated that 10,000 individuals could be affected, poses a significant obstacle. Investing in UBS at present involves a high-risk, high-reward scenario. However, it is crucial to recognize that this acquisition carries inherent risks, particularly in the near term, as circumstances can easily spiral out of control.
Risks to Thesis
The primary risk to my near-term bearish thesis is the possibility of a recession not occurring, which would result in a bull market that increases UBS's assets under management [AUM] and consequently boosts wealth management revenue. Another risk is UBS's ability to execute its plan within the anticipated timeframe of five years.
As I have previously mentioned in this article, a restructuring of this magnitude will not be an easy task. A prime example is the merger involving JPMorgan, Bank One, Chemical Bank, and Chase Manhattan, which took 10 years to complete. It is important to note that this merger involved relatively healthy banks, unlike Credit Suisse, which has faced numerous scandals such as the Tuna Bonds and Archegos Capital. Moreover, Credit Suisse's operations are characterized by their risky nature, particularly their focus on "exotic" products. When UBS de-risks Credit Suisse, it is likely that many clients who were drawn to Credit Suisse because of its exotic products will seek alternatives.
Lastly, I believe it is not the opportune moment to place bets on the August 31 earnings report, as there are too many variables at play. One significant factor is the decision regarding the retention of the Swiss domestic bank, which contradicts the basis of my valuation, assuming UBS does not keep it. Additionally, there are the uncertainties surrounding forecasts and outlooks. Therefore, I recommend a "hold" rating on UBS. It is wiser to wait until the earnings report is released and subsequently analyze the results.
Conclusion
In conclusion, the takeover of Credit Suisse by UBS presents both opportunities and challenges. While UBS aims to enhance its profitability and strengthen its position in the market, there are several factors that need to be considered. UBS's plan to wind down Credit Suisse's operations, particularly the domestic bank, carries risks and uncertainties. The reduction of the balance sheet and the implementation of layoffs within a five-year timeframe require efficient execution. The historical example of bank mergers, such as JPMorgan's, highlights the potential for delays and complications in such large-scale restructuring efforts. Additionally, the inherent risks associated with Credit Suisse's operations and its exposure to exotic products pose challenges in retaining clients during the de-risking process.
The valuation model suggests a promising price target for the new entity, indicating substantial potential for UBS's stock price to increase. However, achieving this target relies heavily on UBS's ability to act swiftly and navigate potential hurdles, including the timing and occurrence of a recession. The company's wealth management division is particularly susceptible to market conditions, which could impact revenues. Considering the uncertainties surrounding UBS's plans, the recommendation is to hold off on making investment decisions until after the upcoming earnings report. This will provide more clarity on UBS's progress, financial performance, and the outlook for the merged entity. A cautious approach is advised due to the high-risk nature of the acquisition and the potential for unforeseen challenges in the near term.
For further details see:
UBS: The Thrill Of Risk And Potential Reward, But Wait For Earnings