UBS’s Cost Cuts Are Promising, But Wealth Management Outflows Are A Concern

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Late last week, UBS (NYSE:UBS) reported a better-than-expected performance for the last quarter of 2016, as improvements in the global securities trading industry coupled with the bank’s efforts to cut costs boosted its bottom line. [1] But a closer look at the results shows that things weren’t too great operationally – especially for its cornerstone wealth management business, which reported outflows of CHF 5.4 billion for the quarter. This in turn led revenues for the bank’s Swiss and International Wealth Management operations (which does not include Wealth Management Americas) to below CHF 1.8 billion for the first time since Q4 2012 – nullifying the impact of record revenues for its Wealth Management Americas division on the top line.

The wealth management outflows were primarily a result of investors pulling out cash stashed in Switzerland ahead of crackdowns by tax authorities around the globe, a trend that is expected to continue over the current year. The shifting preference of large institutional investors towards low cost ETFs from traditional offerings like mutual funds has also resulted in an industry-wide loss of assets for traditional asset managers – hurting UBS’s asset management arm. These headwinds will make it much more difficult for UBS to meet the 15% return on tangible equity target it has set for 2017 – especially since the figure was less than half this target (7.2%) for full year 2016.

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That said, 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 one of the best capitalized global banking giant with a CET1 capital ratio (fully applied) of 13.8% and its leverage ratio (fully applied) reaching 4.6% – both figures comfortably above the target figures that need to be achieved by 2019. Also, one of the factors that hurt UBS’s results for Q4 2016 was unfavorable forex movements. Taking all this into account, and keeping in mind the strong outlook for global securities trading revenues in the near future, we maintain a price estimate of $17.50 for UBS’s stock. This figure is roughly 10% ahead of the current market price.

See our complete analysis of UBS here

UBS_Ear_PBTDiff_16Q4

The table above summarizes the factors that aided UBS’s pre-tax profit figure for Q4 2016 compared to the figures in Q4 2015 and Q3 2016. Notably, Trading & Investment Banking revenues jumped considerably year-on-year, as well as quarter-on-quarter. Total wealth management revenues also nudged higher as the Americas unit reporting record revenues exceeding CHF 2 billion for the quarter thanks to gains from the Fed’s rate hike last December. Gains by the Americas unit absorbed the reduction in recurring and transaction-related fees for the larger Swiss and international wealth management unit. Also, UBS’s Personal and Corporate Banking and Asset Management divisions reported strong revenues for the quarter, and the reduction in “all other revenues” in the table above is completely due to a reduction in non-recurring revenues for the bank’s Corporate Center reporting unit.

Notably, compensation expenses fell compared to the previous quarter as UBS reduced its headcount 1% from almost 60,000 at the end of Q3 2016 to under 59,400 by the end of the year. The year-on-year increase is justified given the sizable increase in revenues compared to Q4 2015 – something that would have increased performance-based incentives. As for other operating expenses, the variations compared to the other quarters was largely due to changes in non-recurring costs like restructuring costs and legal expenses.

The Investment Banking Division Had An Overall Strong Quarter

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 continued to drive revenues for the Swiss bank in Q4 2016 with revenues of CHF 891 million. This represents a sequential increase of 12% and a sharp 22% jump compared to the year-ago period. It must be remembered here that the last quarter of the year is usually a weak period for the seasonal securities trading industry, and the strong show can be largely attributed to increased volatility in equity capital markets globally over the last two months of the year.

The table below details the changes in UBS’s investment banking revenues for Q4 2016 compared to Q4 2015 and Q3 2016.

UBS_Ear_IBRevDiff_16Q4

Notably, each of UBS’s investment banking units reported an increase in revenues compared to Q4 2015. More importantly, the watered-down fixed income, currency and commodities (FICC) trading arm generated revenues of CHF 419 million for the quarter – the first time the figure crossed CHF 400 million for the fourth quarter of a year since 2011. With debt trading revenues expected to remain elevated in the near future, the FICC trading desk should be able to churn out strong revenue gains despite its relatively small size going forward.

Wealth Management Business To Remain UBS’s Key Focus Area Despite Macro-Economic Headwinds

UBS’s revamped business model hinges substantially on its global wealth management business – in fact, it contributes almost 40% of the bank’s share value according to our analysis. After reporting an adjusted pre-tax income figure in excess of CHF 1 billion in Q3 2016, the combined wealth management division saw profits slump to CHF 870 million as fee-based revenues for the Swiss and international wealth management unit declined – something that can be attributed to a net outflow of assets for the division.

The table below summarizes the factors that have led to changes in UBS’s total assets under management across all operating divisions over the last year.

UBS_Ear_AUMDiff_16Q4

Notably, UBS witnessed outflows from its Swiss and international wealth management unit, Americas wealth management unit as well as asset management unit for Q4. It was only thanks to the strong recovery in asset valuation over the period that the bank’s total assets under management swelled to a record high of CHF 2.8 trillion. While UBS also witnessed cash outflows in late 2015, this was due to its strategy of weeding out less profitable clients in an attempt to improve long-term margins. However, the outflows in Q4 2016 were due to clients pulling out cash from Switzerland as the country softens its banking secrecy norms in light of backlash from several key developed and developing nations. This is a macro-level change that is expected to result in outflows for several quarters across the Swiss banking sector with UBS having little control on the trend. But we believe that UBS should be able to counter this to large extent with fresh inflows from Asia-Pacific and Europe. This will help revenues, and in turn profits for the wealth management business to recover steadily in the future.

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Notes:
  1. Fourth Quarter 2016, UBS Financial Releases, Jan 27 2017 []