Undervalued UBS Leads in Wealth Management

UBS UBS reported a net profit of $1.4 billion for the second quarter, roughly the same as the year-ago period. However, it comfortably beat consensus expectations, coming in about 30% higher than the $1 billion consensus had forecast. For the full year, we are 13% ahead of consensus, and this solid quarterly result gives us greater comfort with our estimates. We maintain our fair value estimate and narrow moat rating.

UBS currently trades at 0.95 times its tangible book value, its lowest level in six years. Given its superior profitability, we believe UBS is one of the few European banks that deserves to trade at a premium to its book value. UBS is also trading deep in 4-star territory, and we view the current share price as a good entry point. While UBS is not immune from revenue pressure caused by lower interest rates, we do believe its sensitivity is meaningfully lower than its European retail banking peers’.

The important wealth management business, which contributes 55% of group revenue, reported net new money outflows of $1 billion but is still up $21 billion for the year. Lower net interest margins continue to bite in a challenging rate environment.

Investment banking, which contributes 25% of group revenue, recovered from the disastrous first quarter with profits before tax at $440 million--double the first-quarter 2019 result of $221 million but still 23% lower year on year. Both trading units had revenue declines year on year; foreign-exchange and credit trading pulled back 7%, and equities trading revenue was 9% lower. Despite primary markets and advisory fee pools remaining under pressure, the corporate client solutions segment servicing these markets had an 18% increase in revenue.

Management maintained its single-digit dividend growth guidance, and its intention remains to buy back $1 billion of shares for the year, with only $300 million executed in the first two quarters. Recurring fees in wealth management should benefit from higher invested assets, with markets recovering from the beginning of the year.

Looking to High-Net-Worth Growth UBS was ahead of the curve in anticipating what a global bank should look like in the postcrisis world, and its shareholders are benefiting from its early and decisive actions. Since 2012, UBS has acknowledged that some businesses have become less structurally attractive and reduced its focus on investment banking while also eliminating legacy assets.

Sergio Ermotti, CEO since late 2011, is instead focusing on UBS’ core strengths--its moaty private bank, large asset manager, Swiss retail and commercial divisions, investment banking advisory business, and a handful of successful execution, distribution, and trading businesses.

We believe UBS offers good exposure to some good secular growth stories, such as the increased concentration of wealth, the growth of high-net-worth individuals in emerging markets, and an aging population. Globally, wealth is becoming more concentrated, and the assets of ultra-high-net-worth individuals are growing substantially ahead of global GDP. The growth in wealth will increasingly come from emerging markets, where competition is less intense, and the safety and diversification offered by a Swiss private banking account present an attractive option for investors from volatile regions. An aging population will increase the number of individuals looking for advice on preserving and transferring wealth to the next generation.

The rapid advances in artificial intelligence and the explosion of fintech disruptors pose less of a risk to UBS than to most other global banks. Offering advice to ultra-high-net-worth individuals is not a commoditized business with generic solutions. The complexity of ultra-high-net-worth individuals’ needs makes it unlikely that artificial intelligent solutions (robo-advisors) will be able to replicate the benefits of having a relationship manager.

Moat Comes With Wealth Management UBS is the world's largest wealth manager/private bank, and this great business is the source of our narrow moat rating. We find moats for intangible assets and switching costs in UBS' wealth management operations. We estimate UBS will generate a midcycle return on tangible equity of 13%, ahead of the 10% we believe is a fair cost of equity for the firm; this also suggests the presence of a moat.

In wealth management, a moat for intangible assets is built on a firm’s reputation, specialized expertise, and scope of the services it offers. We also believe that complexity of client needs supports wider moats. The needs of clients become more complex as one moves up the wealth pyramid.

Despite the 2009 bailout by the Swiss government and the 2011 fines for tax evasion to U.S. authorities, UBS has re-established its reputation as the world’s pre-eminent wealth manager/private bank for ultra-high-net-worth individuals. In the 2019 Euromoney Private Banking Survey, UBS was rated first in 9 of 12 global categories, including the best global wealth manager/private bank. The survey reflects the views of competing private banks, which we believe makes it a good indicator of a private bank’s reputation. While a well-known and respected brand is important for attracting clients, it is an equally important consideration for incumbent and prospective bankers/relationship managers.

Since the 2009 crisis, the importance of capital adequacy to a bank’s reputation has also increased. UBS itself saw significant outflows from its wealth management business when there were concerns surrounding its level of capital. UBS subsequently bolstered its capital substantially, and on a core equity Tier 1 basis, it is now one of the best-capitalized banks in Europe. However, its leverage ratio is far less impressive.

The needs of clients become more complex as one moves up the wealth pyramid. We believe that complexity supports moats in wealth management and that catering to ultra-high-net-worth individuals and family offices constitutes a much moatier business than servicing the mass affluent market. Ultra-high-net-worth individuals and family offices have needs that are as complex as institutional investors, if not more so. They may need access to structured financing, generational wealth planning, family office support, and international tax planning, all across multiple geographies. They also tend to have much more complex portfolios, often including family businesses, real estate, hedge funds, and other illiquid assets. Advisors at lower-tier firms are typically unable to deal with these issues. Hiring professionals to address these issues is not cheap, and only a relative handful of companies have enough ultra-rich clients to make the cost worth their while. Many have international holdings, which increases the complexity of compliance with anti-money-laundering, know-your-customer, tax reporting, and other regulations. Ultra-high-net-worth clients value strong relationships with their bankers, typically built up over years, often across generations. UBS is increasingly tilting its client base toward ultra-high-net-worth clients, which currently they make up about 30% of investable assets in the bank’s wealth management operations.

We believe that UBS’ client base, with its more complex banking needs, faces high switching costs. For wealth managers and commercial banks, we believe that switching costs are mostly implicit and include losing a valued relationship with the incumbent advisor, the time necessary to find and vet a new advisor and/or firm, the paperwork involved in moving accounts, and the mental energy needed to choose and approve a new investment vehicle.

These switching costs are all true for UBS as well, but we believe UBS’ ultra-high-net-worth-dominated book faces even higher switching costs. It will have deep relationships with its clients spanning various investment, transactional, and lending products--often integrated--which makes pricing opaque. Products are often tailor-made for the client’s needs, so it is impossible for a client to easily compare pricing. The daunting prospect of untangling the web of products that a client has with a bank is often enough to prevent the client from moving to a competitor.

Private bank clients will typically not only have investment products with their bank. The distinction between a private bank and a wealth manager is blurry and often overlooked. We believe it is important. A private bank that offers its clients transactional and lending products raises switching costs relative to a wealth management business that offers only investment products.

We believe that having an in-house investment bank improves the ability to provide complex solutions to ultra-high-net-worth clients. These individuals are also often entrepreneurs who have banking needs in their business capacity, in addition to their personal needs. The ability to service the client’s business as well as personal needs is a major competitive advantage. However, an investment bank is much more capital-hungry than a pure private bank, and it introduces added risks that may detract from a banks reputation for solidity. In the case of UBS, its investment banking adventures nearly led to the bank’s demise. UBS has pulled back meaningfully on its investment banking business, but we do not believe it exists solely as a product factory for UBS’ wealth management operations.

An evaluation of the banking system that a bank operates in is critical for us to have a high level of conviction in the moats we find for an individual bank. We define a banking system in broader terms than merely the regulatory environment in a particular jurisdiction. Competitive, political, and economic elements also contribute to the robustness of a system to withstand banking crises. Overall, we assign ratings to banking systems in four buckets: very good, good, fair, and poor. We view the Swiss banking system as very good, the only European country that we accord this rating; on a global level, we have an equally positive view of only the Australian and Canadian banking systems.

Market Risk Is Meaningful UBS retains meaningful exposure to market risk despite scaling back and derisking its investment banking activities. Apart from trading, UBS' wealth management and asset management revenue is linked to the market with fees based on assets under management. Additionally, performance fees are more likely to occur in bull than in bear markets. However, the extreme volatility of the postcrisis years is likely to be a thing of the past.

Net interest income makes up only 20% of overall revenue, which is much lower than it is for a typical universal bank. This reduces UBS’ exposure to interest-rate risk. The bulk of the interest-rate risk sits in the U.S. business, where fixed-rate lending dominates, giving rise to a margin squeeze in a rising interest-rate environment.

UBS has one of the lowest exposures to credit risk in our European coverage universe. On-balance-sheet lending is a less important part of the overall business model; loans only make up 35% of the balance sheet. Loans to wealth management clients and Swiss retail and commercial clients make up 90% of all loans; we view these exposures as very low-risk. Also, 95% of the loan book is secured.

UBS has a healthy core equity Tier 1 ratio, but its leverage ratio is barely ahead of its regulatory minimum, which could be problematic in a downturn. A core equity Tier 1 ratio of 13% suggests a comfortable buffer on top of UBS’ fully loaded minimum of 10%. UBS’ leverage ratio of 3.8% is a vast improvement on its precrisis ratio of 0.5%, but it is barely ahead of the fully loaded 3.5% minimum requirement, which will remain UBS’ main capital constraint.

Both UBS’ liquidity coverage ratio and its net stable funding ratio are comfortably above 100%, indicating sound liquidity. To our mind, these ratios, while helpful, do not fully capture liquidity risk. The improvement in UBS’ capital adequacy and the lower exposure to market risk would have bolstered the confidence of both retail and wholesale funders in UBS. We believe these developments are more important than UBS meeting regulatory liquidity risk requirements.