Legal Issues Weigh On UBS Shares Despite Strong Q2 Performance

Better-than-expected earnings for the second quarter of the year by Swiss banking giant UBS (NYSE:UBS) failed to cheer investors earlier this week, as brewing legal trouble overshadowed the results. ^[1] Although revenues for the period were 1.5% lower than the figure for the previous quarter, seasonal effects boost first quarter trading revenues and depress second quarter interest earnings for the bank, implying a strong operating performance across business divisions. Over the quarter, the wealth management operations benefited from an appreciation in value of assets under management as well as from a steady inflow of new money while the investment banking arm benefited from an exceptionally strong equity and debt origination performance. Moreover, adjusting UBS’s operating expenses for the €300 million ($400 million) it paid to settle its cross-border tax dispute with Germany, as well as for other one-time restructuring-related charges, shows that expenses fell to under CHF 5.5 billion ($6 billion) for the quarter – meaningfully impacting its bottom line.

On the flip side, UBS revealed that it is under investigation by several U.S. agencies over its dark pool trading operations, and is also under renewed pressure to settle its tax evasion charges with France. This adds to existing probes into the bank’s foreign exchange business by several countries for manipulating forex rates, as well as for the alleged fraud in Puerto Rico (see UBS Under Criminal Probe For Fraud In Puerto Rico). Taken together, all these legal disputes point towards millions in settlement costs for the bank over the coming quarters.

While we acknowledge the potential downside that exists for UBS’s stock from its legal overhang, we believe that investors are over-reacting to the legal backlog. After all, UBS is one of the best capitalized banks in the world and ranks at the top in the global wealth management industry. Its ongoing restructuring efforts also promise improved profitability in the future. Accordingly, we maintain our $22 price estimate for UBS’s stock, which is about 20% ahead of the current market price.

See our complete analysis of UBS here

Advisory and Underwriting Services Drove Revenues for Investment Banking Division

UBS made drastic changes to its investment banking operations in recent years, announcing plans to reduce its fixed-income trading business to a fraction of its former size by slashing roughly 10,000 jobs. The bank also sought to refocus its efforts away from trading activities in a bid to shrink its balance sheet by freeing capital tied up in the capital-intensive business. The impact of this on UBS’s business model can be seen from the chart above, which shows that trading contributes less than 20% of the bank’s share value – almost 15% for equities trading and less than 4% for fixed-income trading desk.

After the reorganization, the equities trading desk was the single biggest source of revenues for the bank in a quarter – generating roughly CHF 1 billion ($1.1 billion). But these revenues fell 12% quarter-on-quarter and 18% year-on-year to CHF 910 million ($1 billion) in Q2 2014. The much smaller fixed-income trading desk made just under CHF 400 million ($435 million) in revenues – bringing the total trading revenues for the period to a little over CHF 1.3 billion ($1.4 billion). That’s an 8% decline sequentially and a 12% drop compared to the year-ago period.

However, the bank’s advisory and underwriting services more than made up for the decline. These services, which form a part of UBS’s Corporate Client Solutions sub-division, roped in almost a billion Swiss francs in revenues in Q2 2014 – a steep 28% improvement compared to Q1 2014 as well as Q2 2013. Equity underwriting services led the growth with a 78% improvement quarter-on-quarter and a 50% jump year-on-year, followed by a strong performance by debt origination services.

Wealth Management Remains the Mainstay For UBS’s Business Model

UBS’s revamped business model hinges substantially on its global wealth management business, and the unit continued its strong run in Q2 2014. Although the bank’s Swiss and international wealth management operations reported total revenues that were slightly below the figures seen in Q1 2014 and Q2 2013, the bank saw a higher recurring-fee component in this quarter compared to the other two. The unit also saw a healthy inflow of cash in the Asia-Pacific region – helping the total asset base to grow to CHF 928 billion ($1.02 trillion) at the end of the period.

The wealth management operations in Americas also did quite well, with revenues growing 2% sequentially and 7% from a year ago. But the strong results led to higher performance-driven compensation expenses for the division, and the bank ended up with a pre-tax income of $238 million for the period – 13% lower than the record $272-million figure seen last quarter.

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1. 2Q14 Full Report, UBS Earnings Release, Jul 29 2014 [↩]