Strong Q3 Results Show UBS’s Effective Business Model, But Delayed Profit Goal Hurts Shares

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UBS (NYSE:UBS) saw its shares tank nearly 6% over trading on Tuesday, November 3, despite reporting a better-than-expected performance for the third quarter, as investors chose to focus on the bank’s updated performance goals for coming years. ((Third Quarter 2015, UBS Financial Releases, Nov 3 2015)) On the positive side, the largest Swiss bank bucked the trend of a year-on-year reduction in trading revenues seen across the industry to report a sharp improvement in fixed income and equities trading revenues. The bank also did well to ensure that its non-interest expenses (adjusted for one-time legal costs) remained at the same level across Q3 2014, Q2 2015 and Q3 2015.

But investors were unhappy with the fact that UBS delayed its goal of a 15% return on tangible equity by one year – from 2016 to 2017 – owing to the weak economic conditions prevalent worldwide and also due to a projected increase in regulatory and compliance costs in the short term. Moreover, UBS expects the size of its risk-weighed assets (RWAs) to remain around current levels for several quarters, as opposed to a steady decline in this figure estimated earlier. As a result, UBS may have to retain more of its earnings in order to improve its common equity tier 1 (CET1) capital ratio – in turn paying out lower dividends in the medium term.

UBS has proven the strength of its revamped business model on several occasions over recent years by delivering strong results in an environment that has not been conducive to revenue growth in the banking industry. At the same time, UBS remains the best capitalized global banking giant with a CET1 capital ratio (fully applied) of 14.3% and its leverage ratio (fully applied) reaching 4.7% – both figures comfortably above the target figures that need to be achieved by 2019.

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In view of the bank’s delayed profit target, we have reduced our price estimate for UBS’s stock downwards from $25 to $22.50. The new price is roughly 20% ahead of the current market price.

See our complete analysis of UBS here

Trading Desks Perform Exceptionally Well

UBS made drastic changes to its investment banking operations in recent years by announcing plans to reduce its fixed income trading business to a fraction of its former size by slashing roughly 10,000 jobs. The move has proven to be a good one for the bank, as it has helped it achieve the best capital ratio figure among all global banking giants without compromising on its returns. The credit for this primarily goes to the bank’s strong equities trading desk, which did extremely well this quarter and churned out revenues of CHF 944 million ($953 million). Although this represents a sequential reduction of 16%, it is 10% higher than the figure for the year ago period. The year-on-year increase is commendable given the high volatility in equity capital markets around the world on most days during the quarter.

More importantly, the watered-down fixed income, currency and commodities (FICC) trading arm generated a better-than-expected CHF 446 million ($450 million) in revenues – 8% higher than the figure for Q2 2015, and a good 37% higher than the figure for the year-ago period. This is in sharp contrast to declines in FICC trading revenues in the range of 5-35% for the largest U.S. banks. This trend can be attributed to UBS’s decision to retain only those parts of its FICC trading division where it had a sizable market share – something that makes these revenues less volatile compared to those of peers who have much larger FICC trading desks.

Wealth Management Business Impacted By Economic Conditions

UBS’s revamped business model hinges substantially on its global wealth management business – in fact, it contributes almost half of the bank’s share value according to our analysis. After reporting an adjusted pre-tax income figure in excess of CHF 1 billion for two consecutive quarters, the combined wealth management division stumbled in Q3 2015 to report CHF 975 million ($985 million) in operating profits. The decline was primarily due to a reduction in transaction-based income for the Swiss and international wealth management units. With these revenues falling from around CHF 465 million in Q2 2015 as well as Q3 2014 to CHF 366 million now, the marginal improvement in operating costs could not prevent it from dragging down the bottom line. Notably, net inflows for the division were negligible this time around – the result of UBS’s recent strategy of weeding out less profitable clients in an attempt to improve long-term margins. The lower revenues also hurt the division’s adjusted cost to income ratio, which fell to 64% from 62% in Q2 2015 as well as Q3 2014.

UBS’s wealth management unit had a considerably better quarter, as an uptick in revenues and a small reduction in operating expenses helped adjusted pre-tax margins increase to CHF 277 million – a performance that matched the best post-recession showing in Q1 2015. Although transaction-based income for this unit suffered too, an increase in net interest income as well as recurring fees more than made up for the shortfall. The unit also saw a small net inflow of funds for the quarter – after seeing an outflow in the previous quarter.

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