By Erin Davis
On Aug. 13, Julius Baer (JBAXY.PK) announced it had reached an agreement with Bank of America (BAC) to buy Merrill Lynch's non-U.S. international wealth management business, or IWM, for 1.2% of assets under management (CHF 864 million, assuming that CHF 72 billion of AUM is transferred). The opportunistic transaction shows our thesis--that a superior capital base would allow Baer to grow as weaker competitors retrench--is playing out. Shares fell nearly 11% in the two days following the announcement on worries that Merrill's business is not sufficiently attractive and news that the transaction will be financed in part by a rights issue.
The recent price drop presents an attractive buying opportunity for the shares of one of Europe's most well-capitalized, best-run banks, in our opinion. The acquisition, like all wealth management acquisitions, presents material execution risks, but we expect significant rewards for long-term investors. While we caution that profitability may be highly variable during the transition period, we anticipate that greater exposure to fast-growing markets will cement Baer's position as a superior asset gatherer. We think that a strong record on acquisitions bodes well for management's ability to turn around IWM's poor profitability, and that Baer's premium image will boost asset inflows. While we see the recent pricing as attractive, we caution investors considering buying now that their stake in Baer will be slightly diluted if they choose not to participate in the upcoming rights offering. The terms of the rights offering are likely to be finalized after the Sept. 19 extraordinary general meeting.
Purchase Price Is Fair
We see the agreed purchase price of 1.2% of AUM (CHF 684 million-864 million, assuming CHF 57 billion-72 billion of AUM is transferred) as attractive. The price is well below the $2 billion-$3 billion that many analysts had estimated in April when Bank of America put the unit up for sale, which in part reflects the unit's current poor profitability. Comparisons are imperfect because pure-play wealth management transactions are rare, but the price is also attractive relative to past acquisitions and current market prices.
Acquisition Will Accelerate Growth in Key Markets
The acquisition of Merrill's international wealth management business will increase Baer's assets under management by about 40% to approximately CHF 250 billion, with some two thirds of the acquired assets coming from North and Southeast Asia, India, the Middle East, and Latin America. As a result, the percentage of Baer's AUM in growth markets will increase to nearly 50%.
Baer's growth in these markets has driven the firm's overall growth in recent years, and we expect economic growth in these markets to significantly exceed growth in developed markets over the next five years. We project that this stronger growth will support robust net new money inflows and insulate Baer from slow growth in developed markets.
As a result of the acquisition, the proportion of Baer's AUM domiciled in fast-growing markets will increase to nearly 50% from about one third at June 30. This will further diversify Baer's exposure to slower-growing European markets and lessen the proportional impact of any further escalation of the European debt crisis.
Moreover, the acquisition will reduce the relative importance of two key risks facing Swiss banks--the evolving tax regulations that mean slower growth for offshore Swiss banking and the risk that the Swiss National Bank could abandon its peg to the euro. We've historically seen both of these risks as manageable, but are glad to see them lessened.
Transformational Acquisition in 2005 Bodes Well
In September 2005, Baer bought three private banks and a fund manager (later spun out as part of GAM Holding) from UBS, which approximately doubled AUM at the private bank. The group realized CHF 150 million in cost synergies, primarily from consolidating back-office functions, and the bank's stock price increased 50% in the year following the merger announcement despite the large rights issue needed to support the merger. We're encouraged that many of Baer's current managers were instrumental in the 2005 merger's success, including chief operating and risk officer Bernhard Hodler, general counsel Christoph Hiestand, and chief financial officer Dieter Enkelmann. We think Baer's management team is well qualified to manage this complex merger.
Baer Will Improve Merrill's Financial Performance
While few details about IWM's financial performance were disclosed, the unit clearly suffered from neglect as Bank of America searched for a buyer. Baer revealed that the business's cost/income ratio was a loss-making 105% in 2011 (compared with 70% at Baer). Moreover, the unit has attracted little net new money, just 1% of AUM in 2011, as potential clients shied away not knowing who would be the ultimate buyer of the Merrill unit. While we don't expect Merrill's operations to be as profitable as Baer's in the short term, we think profitability will quickly become positive as Merrill sheds Bank of America overhead costs and begins attracting new AUM under Baer's banner.
We think Baer's premium brand will be very effective in helping the new operations to resume attracting net new money, and we note that Baer has historically been a superior asset gatherer to its two biggest competitors, Credit Suisse (CS) and UBS. Management projects that the combined group's cost/income ratio will be 65%-70% by 2015 even if client activity does not improve, primarily as a result of the eliminated overhead. Management further projects that the group's effective tax rate will improve by about 100 basis points to near 15% as a result of geographical changes.
Investors Will Need Patience During Prolonged Transition
We think the recent drop in Baer's share price has created an opportunity for long-term investors who have the patience to stomach volatile headline earnings numbers for two years as Baer digests this complex acquisition. We think management is up to the task, given its successful history of integrating acquisitions, but expect that the transition will be especially complex. Most important, significant uncertainties exist around how much AUM will ultimately be transferred, although this risk is substantially mitigated by the contract's terms that Baer will only pay for AUM actually transferred. Baer must receive regulatory approvals in Switzerland, Hong Kong, Ireland, Singapore, the United Kingdom, and Uruguay. In some cases, AUM will be directly transferred to Baer, but in other cases the bank will need to receive written client consent, which will mean that AUM will be transferred at rates significantly below those in less complex transactions. We expect that during this transition period, Baer's reported earnings will be highly variable; the bank must book the full cost of the purchases at principal closing and about CHF 250 million of restructuring costs, despite immediately receiving only 15%-20% of expected AUM.
Existing Risks Remain
Julius Baer, like all Swiss banks, faces material risks related to worldwide increased governmental interest in cracking down on tax evasion, which has reduced the attractiveness of Swiss offshore banking. These risks will remain post-acquisition, but Baer's larger size will reduce their relative significance. Much of the impact of the erosion in Swiss bank secrecy has already been felt, and additional tax treaties are likely to be signed by the end of 2012, but slow AUM growth in Europe is likely to continue. Moreover, Baer has not yet reached a settlement with the U.S. Department of Justice over charges that it helped U.S. citizens evade taxes before it pulled out of the country in 2008. We expect Baer to pay a sizable fine in order to resolve the charges, but believe it will be able to do so without raising additional capital. Moreover, we expect that any fine will be relatively more manageable by the now larger company.
Currency risks have recently become more important for Swiss banks. In 2011, the Swiss franc began appreciating rapidly against the U.S. dollar and the euro as investors sought a safe haven from the eurozone crisis. This caused profits to fall at Swiss banks, which disproportionately have costs denominated in Swiss francs and revenue in euros and dollars. In September 2011, the Swiss National Bank announced that it was pegging the franc at CHF 1.20 per euro, which stabilized the currency and boosted Swiss bank profits. Since then, the Swiss National Bank's foreign currency reserves have swelled to 71% of Swiss GDP, and 60% of the central bank's reserves are in euros. Speculation has increased as to whether Switzerland will be able to maintain the peg indefinitely, especially considering its rapidly increasing exposure to the euro, or whether it will abandon the peg. If Switzerland did abandon the peg and allow the franc to appreciate, Swiss bank profitability would fall, perhaps sharply. We're pleased, however, that the impact of this risk has been reduced by the increased geographic diversification brought by Baer's acquisition of IWM.