UBS presents an opportunity to buy a world-class wealth management business at an investment banking multiple. As I will detail below, I believe the current stock price of 68 Sfr is at a substantial discount to its intrinsic value of 95 Sfr and sum-of-the-parts value of 86 Sfr (the calculations of which I will describe below). UBS is more of a patient value stock than a catalyst driven story. However, some people view good capital return to shareholders a sufficient catalyst. UBS pays a 2.5% dividend yield and repurchases an additional 3-4% of stock per year. High ROIC, a solid long-term growth outlook, and strong cash return to shareholders makes UBS a terrific patient value stock. Importantly, as I will detail below UBS generates 70% of its earnings from stable, predictable businesses and 30% from its volatile investment banking division. Even when one haircuts these two earnings streams for a bear case on 2008, it is hard to come up with a case where UBS earns less than 5.75 Sfr in 2008. UBS should trade at 12-14x earnings. Thus, it is hard to come up with a case where a bearish turn of events reduces UBS’s intrinsic value below the current stock price.

The reason we have this terrific long-term investment opportunity is that UBS’s investment banking division has introduced some significant volatility to earnings over the past year and recently generated a huge 4bn Sfr loss. The good news is that UBS has changed management and is closing down its prop trading division (known as DRCM) that has introduced the volatility. In a year or so, UBS will transform back to its roots of being a steady performer and 70% of its earnings will come from stable businesses while only 30% will come from the more volatile investment banking division.

Please note that UBS trades in both Switzerland as UBSN.VX and in the US as UBS. I have chosen to discuss all figures for this write-up in Sfr. Thus, my stock price, market cap, earnings, and other figures are in Sfr.

The table below shows how much EBIT and EPS UBS will generate from its various business lines.

EBIT by Business Line

                                                  2006 2007E 2008E

Intl Wealth Management      5,203 6,073 6,901

US Wealth Management         582  687   871

Swiss Business Banking       2,356 2,411 2,381

Global Asset Management   1,383 1,673 1,762

Investment Banking               5,945 1,442 5,772

Corporate                                -1,087  -774   -748

Industrial Holdings               448        455     92

Total                                       14,840   11,968 17,031

Please note that the various segments have different tax rates that actually moves the after-tax net income contribution from the various segments favorably towards the higher multiple segments. Intl Wealth Management has a 19% tax rate, US Wealth Management has a 42% tax rate, Swiss Business Banking has a 20% tax rate, Global Asset Management has a 24% tax rate, and Investment Banking has a 31% tax rate.

This results in the following EPS contribution by business line:

                                              2006   2007E   2008E   % 08 EPS

Intl Wealth Management 1.71      2.39     2.84      44%

US Wealth Management 0.14      0.19      0.26      4%

Swiss Business Banking 0.76      0.94      0.97     15%

Global Asset Management 0.43 0.62     0.68      11%

Investment Banking            1.66 0.48    2.02        31%

Corporate                             -0.34 -0.29 -0.30        -5%

Industrial Holdings            0.14  0.17   0.04         1%

Total                                     5.58 4.50   6.51

I have two ways of computing a fair value for UBS that I will describe below. The first way utilizes a 100-year DCF methodology that I like to use since it avoids a terminal multiple assumption. The second way is a sum-of-the parts blended multiple analysis. The DCF valuation is more favorable than the more conservative assumptions that I used in my sum-of-the-parts calculation, but both point to an exciting value proposition.

In terms of the DCF, it is important to note that UBS has an overall return on tangible equity (ROTE) of 30%. The wealth management/asset management businesses have about a 48% ROTE, and the rest of the businesses have a 20% ROTE, resulting in the overall 30% ROTE. I use a 10.6% discount rate which reflects a blend of the 11% discount rate for the investment banking earnings stream and a lower discount rate for the remaining 70% of earnings. I assume that wealth management international will grow 9-9.5%/year from 2008 – 2014, 8.5% in 2015, 8% in 2016, 7% in 2017-2021, 6% in 2022, and 5.5% per year after that. I assume US wealth management will grow about 6%/year form 2009 – 2015 and 5% from 2015 – 2021 and 3.7%/year after that. I assume the Swiss Business bank grows 3% per year. I assume Global Asset Management grows 5% per year from 2008 – 2024 and 3%/year after that. I assume Investment Banking grows 5%/year from 2008 – 2021 and 4.5%/year after that. You can build your own model and play with the assumptions. The key point is that UBS is a cash flow machine and its various business lines have solid long-term growth potential. UBS should trade at 14.6x fwd earnings based on this NPV analysis.

One key part of UBS’s valuation is its international wealth management business. This business is the primary gem within UBS and it is this segment which generates much of the P/E premium that I believe UBS should have. The international wealth management business consists mainly of Swiss private wealth management with some additional on-shore wealth management in Europe and Asia. UBS is the world’s #1 wealth manager. This business is a terrific franchise that provides a stable, predictable revenue and earnings stream. The model generates roughly 100 bps of revenue for every Sfr of AUM. Most of the 100 bps of revenue come from stable, recurring revenue sources though about 25 bps come from transaction-based revenue that bounces around +- 3 bps. The way this segment grows is though appreciation of existing assets plus net new money. Net new money grew at 8.8% in 2005, 9.5% in 2006, and is running around 10% right now. Appreciation runs at about 5.5%/year as the mix is only about 30-40% in equities. The business generates 48% pre-tax margin which is just phenomenal when compared with the 15-25% margins that the US wealth management firms generate. The reason UBS is able to do this is that the international wealth management business is better than US-wealth management. In Swiss wealth management, the loyalty of individuals lies with the firm as opposed to the individual broker. When a broker leaves, UBS typically keeps most of the assets. The reverse is the case in the US. This allows the firms to have a lower comp ratio and superior economics. Also, UBS caters to ultra high net worth individuals which provides some efficiencies of coverage per Sfr of AUM.

Wealth management has an ROE of somewhere between 50-65%. In my sum of the parts analysis, I suggest this business is worth 16.5x. Actually, in a NPV analysis, this business would be worth anywhere from 17-19x earnings under quite conservative assumptions. If you assume 5.5% net new money (NNM) in years 1-22, 4.5% in years 3-4, 3.5% in 5-6, 1.5% in 7-8, 1% in 9-10, 0% from 11-15, and –1% from years 16 onwards and 5% appreciation from year 1-10 and 4.5% from years 11-onward, you would get a 10.5% growth rate decelerating to 4.5% by year 11 and 3.5% by year 16. This is quite conservative compared to the current rate of about 14-15% growth per year for the past few years. Even this analysis suggests a fair PE of 17-19x depending on whether you use a 10.5% or 10.0% discount rate.

A sum-of-the-parts analysis for UBS looks as follows:

                                                   2008 EPS  PE         Value

Intl Wealth Management         2.84         16.5x    46.8

US Wealth Management         0.26         15.0x     3.8

Swiss Business Banking          0.97        11.0x     10.6

Global Asset Management      0.68        13.5x      9.2

Investment Banking                 2.02         9.5x      19.2

Corporate                                 -0.30         -13.2x    -3.9

Industrial Holdings                 0.04          9.5x       0.3

Total                                        5.58           13.2x    86.2

Note that investment banking represents 31% of 2008 earnings, but only 22% of the sum-of-the-parts value.

There are some important things to say about this investment banking earnings stream.

First, I am assuming revenue of 21,314 in 2008 and a 27% margin. This compares with revenue of 17,448 in 2005 and 21,728 in 2006. However, UBS generated 1,599 and 1,492 from its DRCM prop-trading effort in 2005 and 2006. This is being phased out. Excluding that contribution, UBS did 15,849 and 20,236 in core revenue in 2005 and 2006. Considering that core investment banking and sales & trading has been growing at a 10%+/year trend rate as part of the global boom in financial markets, on can trend these two figures at 10%/year to yield trend revenues of 21,095 and 24,485, respectively.

What’s even more exciting is how UBS looks if you haircut the EPS contribution from the following segments by the following factors:

                                                Haircut Factor     Adj. EPS     Haircut PE     Haircut Val

Intl Wealth Management           6%                 2.67                15.5               41.4

US Wealth Management           6%                0.24                15.0                 3.6

Swiss Business Banking            2%               0.95               11.0                 10.4

Global Asset Management        7%              0.63               13.5                   8.5

Investment Banking                    25%            1.52              10.5                  15.9

Corporate                                    2%              -0.29              13.2                   -3.8

Industrial Holdings                    4%               0.04             9.5                       0.3

Total                                                                   5.75             13.2                   76.4

The key point is that even with an aggressive 25% haircut to investment banking and modest haircuts to the other businesses, UBS will still earn 5.75 Sfr in 2008. A fair NPV-based PE multiple would be around 14.5x. A sun-of-the-parts value using pretty conservative figures suggests 13.2x. UBS used to trade at 12-14x forward earnings until the recent issues in investment banking surfaced. Even if you use only 12x, UBS should be trading for more than it currently trades at. This gives me comfort that we have a margin of safety on this name.

One other point that I’d like to make is that while the stock has had a rough ride over the past 12 months, it has been driven almost exclusively by disappointments in the investment banking division. The revenue and earnings performance of the other segments have been strong and steady and have been tracking at very robust levels. UBS is executing well in all areas except for the investment bank. Even within the investment bank, they are doing well in underwriting and advisory and okay in equity sales & trading. Their problem has been mainly in fixed income sales & trading. Fortunately, they are getting out of the prop-trading area and the remaining client-driven portion where they plan to remain will represent only 34% of expected 2008 investment banking revenue.

The biggest risk to UBS is the risk of further substantial losses from unwinding their DRCM prop book. Unfortunately, we have only limited disclosure to work with in terms of knowing how much is at risk. The DRCM prob book contains a substantial amount of investment-grade rated RMBS and CDOs. We don’t know how much but based on a disclosure in their 2006 10-K, I would guess that it is certainly less than 88bn Sfr and probably less than 50bn Sfr. I’m sure a portion of this is hedged, but it is hard to know how much. What we do know is that this book lost UBS 4.5bn Sfr in Q3 07 in what was a historical degradation to investment-grade RMBS and CDO valuations. We also know that UBS feels that their exposure is within their "risk capacity" which means that it shouldn’t lose more than 70% of their expected next year earnings (so they can pay their dividend) even in extreme market conditions. We also know that spreads on the higher-grade tranches of the ABX indices have stabilized since Sept 30^th (the date that UBS last marked-to-market its book to create the 4.5bn Sfr loss). We also know that the new CEO has every incentive to put this issue behind him and take aggressive marks now so that no further marks will be needed. I can’t give you a 100% guarantee, but I certain think it is unlikely that we will see further substantial markets here. Keep in mind that UBS has 2bn shares outstanding. So, every 4bn Sfr of hit on this book is only 2 SFr/share of intrinsic value. Given that UBS trades at 68 Sfr and is worth anywhere from 86-90 Sfr (and 76 Sfr in my conservative downside-case scenario), it is hard to see how this issue could hit UBS enough to justify the current stock price.