UBS: To Play It Safe (NYSE:UBS)

Last week, UBS Group AG (NYSE:UBS) released its nine-month accounts with a full inclusion of Credit Suisse assets. Post H1 results, we reaffirmed a neutral rating valuation for the combined entity. This was mainly due to a Price-to-book value analysis and a higher execution risk for the integration.

In Q4, the largest Swiss banking group reported a net loss (reported) of $751 million after $1.77 billion in expenses related to the integration (Fig 1). This is the second quarterly net loss after six years. The CEO, Sergio Ermotti, is trying to pivot an earning trajectory growth, managing the most significant financial merger in decades.

Here at the Lab, we believe that Credit Suisse integration is UBS’s top priority, and we are confident that the CEO will successfully lead the bank in the next phase. Sergio Ermotti already achieved a profound cultural change in the previous CEO mandate and allowed clients and stakeholders to regain the bank’s trust following the UBS crisis in 2007-2008. Despite that, the new Group plans to cut more than $13 billion in expenses with many credit metrics below peers. Our internal team believes that the CEO’s additional task will be to continue to proactively approach long-term investors to build a solid investor base and mitigate stock price volatility. According to our base case estimates, this integration process might take at least three years for an entire deployment. We suggest our readers check our previous publication called “First Month With Credit Suisse, Turning More Positive.”

Results and Latest Update

First of all, last time, we positively anticipated that we would be “more inclined if Credit Suisse retail Swiss business were retained. UBS might advance a restructuring plan with higher synergies to boost profitability metrics.” UBS is keen to keep Credit Suisse’s Swiss unit, ending months of speculation. Although UBS is not entirely convinced to use the Credit Suisse brand, the bank’s executives have indicated a preference to maintain and integrate Credit Suisse’s domestic operations rather than pursuing a spin-off or a listing. According to Bloomberg, there would also be a political motivation behind it. The possible merger of Credit Suisse’s domestic division will have consequences for staff, with cuts on the horizon. UBS disclosed that is accelerating Credit Suisse’s asset liquidation to reduce risk-weighted assets by $6.4 billion.

Cross-checking Wall Street numbers, the net loss is slightly lower than the consensus estimate, which expected a red of $285 million compared to actual results minus $278 million (Fig 1). Revenues fell to $10.41 billion from $11.7 billion in the third quarter. However, the bank has not given up on the dividend. In fact, it has proposed a DPS of $0.70 per share for 2023, an increase of 27%, compared to a net profit attributable to shareholders for the entire 2023 financial year. Looking at UBS’ key division (Wealth management – Fig 2), the segment recorded a pre-tax profit of $381 million, a figure significantly below analysts’ estimates of $1.07 billion. However, the division’s net collection was $21.8 billion, higher than expected. As a reminder, the combined entity has reached a higher AuM of $77 billion in 2023. The division reported net client inflows of $21.8 billion, while Credit Suisse’s wealth management business delivered a positive flow for the first time in a year and a half. This ends the wealth exodus of many clients. UBS explained that continued uncertainty about the economic outlook, including central bank rate increases and geopolitical tensions, may influence client decisions on asset flow.

Source: UBS Q4 results presentation – Fig 1

Fig 2

Given the complex internal scenario, UBS has slightly revised its record profit in fiscal 2023 from $29 billion to $27.8 billion, following adjustments to Credit Suisse’s estimated value. This higher profit was inflated by an accounting gain resulting from the difference between the CHF 3 billion paid to take over Credit Suisse and the value of net assets accounted for. After making adjustments of $1.2 billion on a negative goodwill amortization, the net profit was corrected to $27.8 billion.

What is critical to report is the latest update from the Swiss Federal Council. Looking at the details, the Swiss Finance Minister and Confederation Vice President require higher capital guarantees to protect the banks’ balance sheets. The Federal Council would want more capital for UBS’s foreign subsidiaries, while bank-specific capital levels should be increased to better respond to future risks. The proposals would see UBS face a “substantial” increase in regulatory requirements. There is no precise timeframe, but we believe the Federal Council intends to present this implementation to the Parliament in H1 2025. The government might change the bank’s capital regime without Parliament’s approval. Applying the new legislation would, in any case, come into force no earlier than 2026. In addition, the Federal Council does not consider prohibiting variable remuneration.

That said, the language is hawkish on capital, and we might expect a strengthening of between $15 and $25 billion in UBS capital. If we take a step back, even if this were early days in the CS transaction, this was one of the reasons why we Resume UBS coverage With An Equal-Weight Valuation. That said, we believe this impact looks manageable and should not trigger a significant change in UBS capital return potential. This is why the dividend was also confirmed. However, we might expect a lower-than-forecasted buyback.

UBS’s Common Equity Tier 1 capital ratio increased to 14.4% at the end of the year (Fig 3) and remains a fundamental pillar of the company’s strategy. According to the CEO, “they anticipate maintaining a CET 1 ratio of approximately 14% throughout the integration period.”

Fig 3

Earnings changes

The bank provides a business plan for the next three years (Fig 4). These include transition effects in order to achieve a <70% cost/income ratio by end-2026. In the plan, there is also a “2026 exit rate” with a positive evolution of capital balance sheet strength and a reduction of RWA. In our analysis, we also take into account that the company has at least $9 billion in additional integration costs. Indeed, UBS delivered $4.7 billion of acquisition-related costs and integration expenses in 2023. Total headcount was reduced by approximately 3,000 units in Q4. Here at the Lab, in our assessment, we also plan loan loss provisions of roughly $500 million per year until 2026. And we anticipate restructuring costs of $4.7 and $2.4 billion in 2024 and 2025, respectively. In our numbers, we arrive at a profit before tax of $5.2 billion and $10.8 billion in 2024 and 2025, with an EPS of $0.9 and $2.8. Our 2024-25 estimates reflect the new company’s new financial targets and a longer transition to clean earnings power. Reverse engineering UBS 2027 estimates that the bank plans to become a $4 EPS bank in 2027 with a CET1 of 14.6%.

Fig 4

Valuation

EU banks are valued at 0.8x price-to-book and P/E in the 6/7x range. UBS’s tangible book value per share stands at $24.86 per share vs. a current stock price of $28. Therefore, UBS is valued above its EU peers’ average with a PBT of 1.12x. On a P/E basis, looking backward, the company trades at 8x; however, considering integration costs and higher cost/income, UBS’s P/E reached 31x in 2024 and 10x in 2025. Applying a $4 EPS target in 2027, we arrive at a normalised P/E of 7x.

Taking into consideration JPM, Goldman Sachs, and Morgan Stanley’s next TTM P/E estimates, they are trading on average at a 10x multiple. Looking at the three major US players, the average book value per share is at 1.03x. To play it safe, UBS is in the middle of its biggest integration process; therefore, given the P&L volatility, we prefer to value UBS on its book value per share. Valuing UBS with a PBT of 1x, we derive a value of $24.86 per share.

Risks

Downside risks to our target price include 1) regulatory changes and their potential impact on CET 1 requirements and earnings (Swiss Federal Council is a clear example), 2) a negative interest rate environment, 3) higher integration costs from Credit Suisse acquisition, 4) cost pressure, and 5) lower capital market revenues couple with earnings volatility in CIB. In addition, we should also report a Swiss slowdown in commercial and personal loan activities.

Conclusion

Notwithstanding UBS integration costs, and looking at the latest regulatory potential impact, the bank should be able to absorb these changes. That said, rolling forward our valuation, we continue to see a full value in UBS shares. Therefore, we reiterate our equal weight rating.