Credit Suisse Is A Trap

| About: Credit Suisse (CS)

Summary

Credit Suisse is one of the largest global banks with sizable operations in investment banking and wealth management.

The bank has had weak results due to several issues over the past few years and its current restructuring program seems to be already outdated.

Its main attractiveness is the dividend yield of 7%, but until it fixes its structural issues Credit Suisse is a trap.

Credit Suisse (NYSE:CS) is one of largest global banks, with significant operations in investment banking and wealth management. Over the past few years, its financial performance has been very weak and the bank has now a new strategy focused on Wealth Management and targeting growth opportunities in Asia. However, its aggressive plan seems already outdated and further actions may be needed. Despite its attractive dividend yield, Credit Suisse seems to be a trap until it fixes its many structural issues.

Company Description

Credit Suisse is a leading investment and private banking group, which was founded in 1856 and is one of the two Swiss big banks, which also includes its closest peer UBS Group AG (NYSE:UBS). Its Wealth Management business is among the global leaders in terms of assets under management, profitability and potential growth. Its global Investment Banking ranks among the largest in fixed income and equities. It has also significant retail banking operations in its domestic market. Other operations include Asset Management, which has recently narrowed its product and geographical focus. It is a Global Systemically Important Bank (GSIB) with a buffer of 1.5%.

Credit Suisse has a market capitalization of about $21 billion and trades in the U.S. on the New York Stock Exchange through its ADR program. Its closest competitors are other global banks like UBS, Deutsche Bank (NYSE:DB), HSBC (NYSE:HSBC), Barclays (NYSE:BCS), Citigroup (NYSE:C) or JP Morgan (NYSE:JPM).

Credit Suisse operations are divided into four main segments, namely Investment banking (IB), Private banking, Corporate and institutional banking (CIB) and Asset management. In the past year, its largest division was investment banking generating more than half of group revenues, followed by private banking (34% of revenues), while CIB and asset management together represented 14% of revenues. Measured by operating income, private banking is the largest segment due to its superior profitability within the group.

Strategy & Financial Overview

Like many of its peers, Credit Suisse has been negatively affected by low volumes on its global markets operations. Contrary to its closest peer UBS, which withdraw almost completely from fixed income markets, Credit Suisse has a very large presence on fixed income, commodities and currencies (FICC). This area has been one of the most affected since the global financial crisis of 2008-09 by weak volumes, which has penalized revenues and profitability. Even though the bank has made substantial restructuring and deleveraging over the past few years, it still is heavily dependent on FICC within its investment banking business.

Regarding its financial performance, Credit Suisse has delivered weak earnings over the past few years, like many of its global banking peers. Credit Suisse has been negatively affected by several issues, including weak volumes in its global markets division, the low interest rate environment in Europe and significant litigation costs due to past misconduct.

Given this weak backdrop, Credit Suisse changed its leadership in 2015 and hired Tidjane Thiam from the insurance company Prudential Plc (NYSE:PUK). After that the bank presented a new strategic plan and performed a capital increase, aiming to strengthen its position on private banking and wealth management and its capital ratios. Geographically, it intends to grow in Asia Pacific and other emerging markets, where it has better wealth management growth prospects.

It also has the goal of improving considerably its profitability, targeting a return on tangible equity (RoTE) of around 14% by 2018. This seems very ambitious and a markedly improvement from the past few years, given that its RoTE has been around 5% and in the last year the bank reported losses. To achieve its target the bank relies on aggressive revenue growth assumptions but Credit Suisse also has a cost savings program ongoing, targeting about $4.3 billion of gross savings by 2018, or $1.4 billion per year. To achieve these targets it will simplify platforms, shrink its footprint and make a number of disposals and closures.

These targets seem aggressive, especially considering that despite the actions already taken and its new strategy plan being in place, its most recent financial results continue to be weak showing the structural issues that it still faces and how difficult is to turn around a large bank like Credit Suisse in a short period of time.

During the first quarter of 2016, Credit Suisse was negatively affected by one of the weakest quarters on capital markets activities and losses of about $1 billion in illiquid assets. Due to these losses, it decided to exit distressed credit and European securitized products trading within its Global Markets activities. Its revenues declined to $4.7 billion in the past quarter, a decline of 30% from the same quarter of the previous year. Its net income was negative by around $300 million, while a year ago it reported more than $1 billion of profit.

This weak results increased investors skepticism towards its financial goals and Credit Suisse has announced another strategy day for the last quarter of this year, probably setting new goals with less reliance on macroeconomic and capital market trends compared to its current goals, especially considering that its previous plans were made before the 'Brexit' event that increases uncertainty on its business outlook in the medium-term.

Capital & Dividends

Regarding capitalization, Credit Suisse has improved its ratios recently through a capital increase of about $6 billion performed in October, 2015, but it still lags some of its closest peers. At the end of March, 2016, its fully loaded core equity tier 1 (FL CET1) ratio was 11.4% and its CET1 leverage ratio was 3.3%. These ratios are acceptable but lower than for UBS and its own capitalization targets set for 2018. Credit Suisse's goal is to strengthen organically its capital base over the next few years, reaching a FL CET1 ratio of 13% at the end of 2018 and at least 3.5% CET1 leverage ratio. Its total leverage ratio is expected to be about 5-6%, including additional tier 1 capital.

This means that compared to its own targets, Credit Suisse has a capital shortfall of about $5 billion. It intends to close this shortfall through retained earnings and plans to perform a partial IPO of its Swiss universal bank, which is mainly focused on Swiss-domiciled clients. Its goal is to sell 20-30% of this unit, which may have a positive impact on group capital between $2-4 billion depending on pricing. Even though this is subject to favorable market conditions, the bank should be able to sell a sizable stake and increase its capitalization towards its targets.

Regarding its shareholder remuneration, Credit Suisse has delivered a flat dividend over the past few years despite its huge losses in the past year. Its dividend has been flat at CHF 0.70 per share ($0.72), representing at its current share price a very attractive dividend yield of about 7%. Shareholders had the option to receive cash or new shares and about 70% of Credit Suisse's 2015 distribution was made in the form of scrip (new shares), diluting the remaining shareholders that chosen to receive cash.

For the next couple of years, the bank has indicated that it plans to maintain a flat dividend, which should also contain optional scrip alternatives. This means that Credit Suisse should not deliver dividend growth and further dilution is expected ahead for shareholders that don't want to receive new shares. After 2017, it intends to have a dividend payout of at least 40%, below the European banking sector average.

Even though its dividend yield is attractive, due to the bank's weak financial performance in 2015, its dividend was not supported by earnings and this may be also the case in 2016. This is obviously a negative sign for its sustainability over the long-term and its high-dividend yield is therefore highly speculative. The risk of a dividend cut is considerable and dividend investors are making a bet on future earnings that is risky given the many issues Credit Suisse currently faces, like delivery on restructuring, litigation risk and thin capitalization compared to regulatory requirements.

Conclusion

Like many of its global European banking peers, Credit Suisse currently trades at a very low valuation at 0.44x book value, that seems to be more of a value trap than a long-term opportunity. The bank faces structural issues and its new strategy presented in 2015 seems to be already outdated, especially considering the increased uncertainty created by the recent U.K. referendum. The most positive factor of Credit Suisse's investment case is its attractive dividend yield of about 7%, but its dividend cut risk is relatively high. Therefore, Credit Suisse seems to be a clear value trap, until it shows signs of successful business turnaround and significant capital build-up something that may take at least two years to materialize.

Disclosure: I am/we are long UBS, HSBC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.