Description

The stock is question is UBS, which is in the process of acquiring Credit Suisse.

Here’s a SOTP valuation on UBS as a standalone entity.

UBS STANDALONE

The first and most important business for UBS is wealth management. At the end of Q4, UBS wealth management had $2.8 trillion in AUM, with $1.3 trillion in fee generating assets. Multiples for wealth managers are driven primarily by two factors – the company’s success in delivery organic asset growth and fee compression.

With that in mind, below is a snapshot of relevant metrics for the UBS wealth management business. This looks healthy to me. The company saw organic AUM growth for 12 consecutive quarters, averaging 0.6% per quarter. The regional mix is shifting a bit towards APAC.  Not seeing a lot of fee compression.

Charles Schwab (SCHW) is a decent comp for UBS wealth management. Schwab’s organic asset growth has been a bit healthier than UBS (averaging 1.6% per quarter for the last two years). SCHW is trading for 13x earnings post the SVB crisis (which led to the realization that Schwab banking is holding $12b in unrealized losses, with $8.3b of those related to agency mortgages).  Without that balance sheet issue, SCHW would be closer to 15x.

A a 9x EBT multiple on the UBS wealth management would seem to be on the conservative side. Although the UBS wealth management business has seen consistent AUM growth, fee compression is the dominant secular trend in this industry, and I think it’s safe to assume fees will be gradually fall over time.

The next business is asset management. The key operating metrics are below. For asset management, we observe slightly heathier organic growth – averaging 1.2% for the last 12 quarters – but clearer evidence of fee compression. That said, the starting point of fees (20bps) is fairly low.  I’m using 10x EBT multiple for this business.

Next is Personal and Corporate Banking, which is a traditional consumer and corporate bank. Although all banks are black boxes to a certain extent, lending standards are probably quite good, as evidenced by the limited losses UBS and other European banks suffered during COVID-19.

Below is a comp sheet covering some of the larger banks in Europe. Across the board we observe strong capital ratios and NPL ratios. Just like in the U.S., much of the riskiest corporate lending today is being done by the shadow banking system. Today, most European banks are focused on consumer mortgages, secured corporate lending and unsecured debt to consumers (provided they have good credit stats). 

Below is a breakdown of loans from the UBS P&CB segment. Unsecured consumer loans, which have historically comprised the largest source of defaults in Europe, are only 8% of the UBS loan book.

LTV ratios for the residential mortgage book are provided below. More than 80% of the mortgage book is less than 50% LTV.

I’m going to put a 0.75x tangible book value multiple on this business. That’s equivalent to me writing off approximately 3% of risk-weighted assets, above and beyond the banks’ existing loss provisions.

Last is investment banking. Investment banks have been over-earning for the last few years. The rising interest rate environment is likely to lead to a prolonged deal drought. Fortunately for UBS, the bank has been less weighted towards advisory/cap markets. I still think it’s appropriate to be conservative. I’m using a sub-1x TBV multiple here which amounts to 4.5x PBT for 2022.

Add it all together and I get to $20/share, which is roughly where UBS is trading right now.

CS DEAL IMPLICATIONS

Before doing any math, it’s important to understand that prior to this merger, CS was trading poorly due to concerns about the company’s capital ratios.  These concerns were contributing to outflows in wealth management.  The market believed CS would be forced to do due dilutive equity issuances to support the balance sheet. The UBS deal helps negate those concerns because the combined entity is clearly solvent.

Let's start tallying up the potential value creation. First, CS has approximately $600b in AUM for its wealth management business, with those clients paying roughly the same fees as what UBS charges. UBS can tuck those assets in. There are likely to be some negative synergies here, as some customers currently working with both banks won’t want to concentrate their assets. However, there's also likely to be operating leverage.  This is approximately $10b in value creation using the UBS fee structure.

The CS asset management business has $400b in AUM for asset management. Fee structure here is also quite similar. That’s another $7b in value for CS assuming no operating leverage.

The CS Swiss bank has $9b in tangible book value. Just like with UBS, the CS consumer and corporate bank has limited exposure to consumer unsecured, which comprise just 5% of loans.  Let's use $7.5b here.

The CS investment bank isn’t worth much. The division generated losses in a very accommodating market. UBS will probably take a few rainmakers out of IBD and fire 85% of the workforce. There will likely be substantial restructuring costs associated with the wind-down. That said, I’m reluctant to assign significant negative value because the investment banking book has roughly $10b of tangible equity which will help pay for its own wind-down.

Also, as a reminder UBS paid a negative price tag for the tangible book value because of the AT1 write-off.  Add it all up and I'm at roughly $32/share.

I anticipate some push-back.  Namely:

For UBS shareholders, this CS deal is a rug-pull. Investors who owned UBS stock did so because it had a low risk profile and strong capital cushions.  This deal is moving in the opposite direction and adds confusion.  The restructuring will generate losses, making it hard for the stock to attract buyers when there are other banks in Europe that trade cheaper on forward earnings.

I think this helps explain why UBS stock isn’t already shooting up, despite what seems to be a highly accretive deal.  In time, I suspect, UBS will digest CS and go back to being a boring stock with broader appear. 

Market consolidation is the biggest driver of ROTEs in European banking.  UBS just eliminated their strongest competitor.  That's a huge source of value-creation not incorporated into the math above.  UBS did $2.40/share in EPS last year.  Is it really hard to imagine that the combined entity would be doing $4.50 of EPS in the out years at a 15x multiple?  My base case is the math above, but I think the blue-sky here approaches $70/share. 

Catalyst

More clarity on restructuring costs and the earnings power of the pro forma entity.