Trading at 9.5x 2007 EPS and 8.5x 2008 EPS, CS presents a very compelling and timely investment opportunity . The market is currently underestimating Credit Suisse’s earnings power (as you see below, I expect CS to earn 9.81 CHF in 2007 vs. consensus of 7.72) and is not awarding the company the multiple it deserves given its business mix. Key to my thesis and target is the fact that Credit Suisse generates 40% of its net income from wealth management.  There are different types of wealth management businesses out there, but Credit Suisse’s franchise and business model is a particularly compelling one as I discuss below.  Because of the robust competitive position and strong growth outlook, this business is worth at least 17x earnings.  I get a pretty exciting upside target whether I use a sum-of-the-parts approach that accounts for CS powerful business mix or a DCF/fair multiple approach on the overall business.

 

I expect CS to hit 125-130 CHF in 1-year, which represents approximately a 35% return from the current stock price of 95 CHF (note, the stock price in the header of this write-up is quoted in US dollars, but all the figures in the body of this write-up are in Swiss Fancs (CHF). Please note that CS trades in Switzerland as “CSGN.VX” and in the US as “CS”.

 

What makes Credit Suisse’s story even more compelling is that I think there is a significant catalyst for immediate value realization.  Credit Suisse over the past year and particularly in Q406 has shown accelerating momentum in its investment banking division.  In fact, Q406 was an absolute blow-out.  I believe the factors that drove the Q406 blow-out are sustainable and not one-time anomalies, but the analyst community has chosen to take a more cautious wait-and-see attitude and I think they are significantly underestimating 2007 and 2008 earnings power as a result.  Upward revisions throughout the course of 2007 should provide a catalyst for value realization.

 

Credit Suisse is expected to report earnings on May 2^nd (1AM EST).  Predicting the earnings of an investment bank from quarter to quarter is very difficult due to the lumpy nature of the earnings.  However, as it turns out, there are a number of items that investors can track to get a handle on how things good.  There are overall stats on trading volume (US and international) in equities and fixed income.  Those can be helpful directionally.  However, the best thing to look at is the results of the companies as they come in at an aggregate level to look at the health of the market.  As it turns out, all of the US investment banks and money center banks with significant IB operations have reported: GS, MS, MER, LEH, BSC, JPM, and C.  I have done extensive work analyze the relationship between these various companies individually and in aggregate with the various segments of CS’s investment bank, and my work gives me added conviction in my view that they are going to significantly beat earnings.  I am expecting 2.67 CHF per share versus consensus of 2.17 CHF.  If earnings come in significantly above consensus as I expect, I believe the analysts will revisit their view of the earnings trajectory for the rest of the year and come in close  to my expected 9.81 CHF for 2007 vs. their current 7.72 consensus.  Meaningful upward revisions will help bring more focus to this stock and over time I think we will get a higher multiple on higher earnings as the market gives full credit to CS’s business mix.

 

I want to emphasize that my underlying excitement for this idea is not in my expectation of a quarterly surprise but rather in the discount to long-term intrinsic value that I see. My expectation of an EPS beat is just the gravy to my thesis.  The most important part of my thesis is that the wealth and asset management operations of CS are great businesses and they are not being properly valued.  My expectation of a quarterly surprise is just a bonus that provides a catalyst for value realization.

 

The key investment points on CS are as follows:

1)       Significant discount to NPV and sum-of-the-parts valuation; significantly underappreciated business mix

2)       Favorable industry structure with strong long-term growth dynamics

3)       Underappreciated company-specific margin expansion opportunity

4)       Strong free cash flow generation; excess capital; dividend and share repurchase program in place

5)       Low valuation provides margin of safety even if downside scenario unfolds

6)       Alignment between short term and long term prospects; May 2^nd Q107 EPS report and expected upward revisions to consensus should be a meaningful catalysts for fair value realization

 

 

 

                                Q107                      2007                       2008                      

JNA341 EPS                         2.67                        9.81                        10.94                     

Consensus EPS                    2.17                        7.72                        8.55

JNA341 Rev                         12,119                   45,681                   48,733

Consensus Rev                    10,251                   38,700                   40.400

JNA341 PE                                                           9.5x                        8.5x

 

 

Significant discount to NPV and sum-of-the-parts valuation; significantly underappreciated long-term earnings power

 

Wealth management is a great business that represents ~35% of earnings.  CS is the #2 market share player in this large, growing market with a franchise focused on private banking for high-net-worth and ultra-high-net-worth individuals.  Scale, systems, and access to sophisticated financial products are becoming key differentiators that are allowing Credit Suisse and UBS (the #1 market share player) to gain share at the expense of the smaller, local players.  Wealth management has an incremental return-on-equity that is over 50% and generates excellent free cash flow even when it is growing.  Credit Suisse should be able to grow net new money at over 6% and generate an annual investment return of over 5%,  This should allow for a 3-5 year top-line organic growth rate of over 11%.  This growth rate combined with some expected margin expansion and strong free-cash-flow conversion is worth 20-24x forward earnings on a NPV/DCF basis.  However, one does not have to award the business such a healthy multiple to get big returns from the investment in CS.  Merely using a 17x multiple on wealth management and a 9x multiple on investment banking generates a price target that is over 40% higher than the current stock price. 

 

The challenge in analyzing most investment banks is that advisory and sales & trading revenue streams are very volatile, and it is hard to know what the normalized earnings power and sustainable growth rates truly are.  The investment banks have had a terrific run since 2002, and there is a fear out there that they may be over-earning right now.  I happen to be a believer in the investment banking business and think that both the advisory and sales & trading businesses have long-term secular growth rates that are over 2x GDP growth and that they are currently not significantly over-earning (i.e. above normalized trend).  If my belief is right, the investment banking business should be trading at over 14x earnings.  However, reasonable people can disagree, and I cannot completely refute arguments that suggest that the investment banking business is only worth 8x or 9x earnings.  The beauty of the wealth management business is that it is more stable and thus it is easier to estimate normalized earnings from current earnings power.  While reasonable people can disagree as to the fair value of both the wealth management and investment banking businesses, the range of difference on wealth management is smaller.  It gives us great comfort that I can justify a meaningfully higher stock price on CS by awarding wealth management a 17x forward multiple and investment banking a conservative 9x multiple.

 

It is worth pointing out that there are positive synergies between the wealth management and investment banking businesses that could make the sum of the two worth more than the individual parts over time.  Quite simply, an investment banking franchise helps introduce ultra-high-net-worth clients to the wealth management business.  Furthermore, clients of wealth management are becoming more sophisticated over time and are demanding products such as CDOs and derivatives that are best provided by an integrated investment bank.

 

 

 

Favorable industry structure with strong long-term growth dynamics

 

Both wealth management and investment banking are secular growth markets.  Credit Suisse’s wealth management business caters to high-net-worth individuals who are seeking the services of a private bank.  Credit Suisse has a global presence that is particularly strong in Europe and Asia, and is a beneficiary of the boom in global wealth creation.  As economies expand and wealth grows, Credit Suisse benefits.  Wealth management is still a fragmented industry with a many local players, but as customers become more demanding and as technology and infrastructure are becoming more important, CS and UBS are gaining share at the expense of the small players.  Not only is scale important, but so is having integrated investment banking and wealth management capabilities. 

 

Investment banking and sales & trading are also powerful growth markets that have historically grown at over 2x GDP growth and are expected to continue to grow strongly as economies across the world develop their capital markets infrastructure.  In fact, we are in a boom time right now as economies across Europe and Asia adopt American-style capitalism and embrace capital markets.  Capital markets are displacing traditional banking across Europe and Asia and the investment banks benefit from this.

 

Underappreciated company-specific margin expansion opportunity

 

While the investment case in Credit Suisse can stand on its own based on the factors mentioned above, Credit Suisse has an added kicker that separates it from the other investment banks.  Due to some company-specific historical factors, Credit Suisse’s cost structure on the investment banking division is somewhat out of line from peers and margins are lower than they should be for a company of its size.  Credit Suisse has announced a very credible plan to close the gap on margins.  This plan is a top focus of top management, and the people who have been hired to implement it and the process that has been put in place to execute on this opportunity are very credible in my opinion.  The market has kept its expectations from this opportunity relatively low, and Ithink that additional upside will come from successfully executing on this plan.

 

For those of you who wish to research this aspect of the story further, refer to presentations or analyst notes that talk about the “Mark Rufeh” cost cutting initiatives.  Mr. Rufeh was formerly form Lehman Brothers and was hired to spearhead the margin improvement initiatives.

 

Strong free cash flow generation; excess capital; dividend and share repurchase program in place

 

CS currently has CHF 8bn of excess capital, which represents over 8% of the current market cap.  Furthermore, the company generates strong free cash flow, even during period when it is investing in growth (this is driven by the 50%+ ROE in the wealth management business).  CS pays a 3.1% dividend, and is planning to buying back over CHF8bn of stock over the next three years.  This will result in a total rate of capital return that exceeds 5.7% per year, and I see potential for the actual return of capital to be even higher.  Most importantly, this capital return will not come at the expense of growth, and I expect CS to grow its business strongly while the capital is being returned.  The ability to do this is a product of the company’s high ROE.

 

Low valuation provides margin of safety even if downside scenario unfolds

 

Whenever one looks at market-sensitive businesses, it is important to realize that there is tremendous uncertainty to what the future will bring.  Areas that are running hot can suddenly turn cold. The stock market can have a correction or even a crash.  The future for CS is best captured as a series of upside and downside cases around a best guess point estimate.  When dealing with a business that has such intrinsic volatility, it gives me great comfort that I can use low multiples on the businesses with the greatest uncertainty and still get powerful upside.  CS currently trades at 9.5x and 8.5x my base-case point estimate for 2007 and 2008 EPS.  I believe this valuation is sufficiently low that it gives us a comfortable margin of safety that allows us to sleep well at night in a space that is notorious for its volatility.

The biggest risk to CS is a significant decline in the global equity and debt markets.  Wealth management’s earnings power is directly related to assets under management, and a big decline in asset values would have a direct hit to the fees that the business generates.  Poor equity market performance and/or widening credit spreads would also have a negative impact on investment banking and sales and trading revenue.  Credit Suisse has a particularly strong franchise in leveraged finance and the company’s investment banking division has more exposure to private equity activity than many other peers.  Some see a bubble in private equity/leveraged finance, and if that business falls apart like some skeptics fear, CS would take a meaningful hit on its investment banking business.  In addition to such fundamental risk factors, it is impossible to ignore that in the short term, investment banks are very volatile and can have big downward signs that are driven more by sentiment than economic reality. 

 

 

Background/Initiation

·         CS Investor Presentation at ML Financial Conference 11/16/2006

·         CS Investor Day Slides 1/22/2007

 

Important Industry Notes

·         Bear Stearns 4/11/2006: “The Wealth Management Industry: Show Me the Money”—excellent note

·         Bear Stearns 1/5/2007: “The European Investment Banks: Breathing in the Fumes in the Capital Market Race”—an excellent note of the trends and relative performance of the top 10 global investment banks across all areas of the investment banking and S&T business