Like Barclays, Credit Suisse Offers An Interesting Risk Reward Play

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About: Credit Suisse Group AG (CS), Includes: BAC, BCS, C, SAN
by: Khen Elazar
Summary

Credit Suisse is a major European bank that enjoys improving fundamentals due to a massive restructuring process and an attractive valuation.

The restructuring process will improve profitability in the coming three years.

Credit Suisse is riskier than the American banks. However, it also offers a better reward-risk ratio, and investors with a higher appetite for risk should consider it.

Introduction

Credit Suisse (CS) is the second largest bank in Switzerland. It suffered greatly from the financial crisis of 2008 and the European sovereign debt crisis of 2010. The bank is enjoying improving fundamentals over the past three years and is forecasted to improve its profitability metrics in the coming three years as well. Investors can take advantage of the low valuation for a higher-than-average return.

Investors should focus on the restructuring plan and its success. The company is measuring the success with top-line growth in key sectors and the improvement in crucial profitability metrics such as return on equity. At the same time, net income has more than doubled, and robust growth is forecasted to continue. The bank will also start focusing on rewarding shareholders with buybacks and growing dividends.

On the negative side, investors should also pay attention to the leverage and liquidity metrics. The company exercised a very risky approach, and it backfired in 2008 and 2010. It is still recovering, and while the company states that it plans to be more conservative in the future, investors should still pay attention to it.

Credit Suisse has some similarities to Barclays (BCS) and Santander (SAN), which I analyzed in the past. They are risky securities from the same sector, but they also hold great return potential. Investors who look for riskier stocks with higher-than-average potential returns should investigate them.

Credit Suisse engages in the provision of financial services. It operates through the following segments: Swiss Universal Bank, International Wealth Management, Asia Pacific, Global Markets, Investment Banking and Capital Markets, and Strategic Resolution Unit. The company was founded by Alfred Escher on July 5, 1856, and is headquartered in Zurich, Switzerland.

Image result for credit suisse logo

Source: Wikipedia.org

Fundamentals

When I looked at the overview of Credit Suisse, I expected to see a bank with struggling fundamentals, but I was surprised. Revenues over the past several years were flat (in CHF). However, it doesn't tell the whole story. The company is going through a restructuring process, and it focuses on specific lucrative and profitable business segments. The company achieved 5% sales growth in its international banking capital market and wealth management segments, and it is growing according to plan.

Chart Data by YCharts

The company's approach is to put value over volume. We see it in many banks around the world, where the less profitable activities are divested. CS manages to grow its top line where it matters, and the effect on the bottom line is robust. Profits have doubled over the past three years, and in Q4 2018, they soared almost 50% despite weak returns in the stock markets. The company expects the restructuring to continue and deliver top- and bottom-line growth.

Source: Full-Year 2018 Results

Dividend growth investors focus on the dividend. With the EPS doubling in the past three years, there is more room for dividend growth. After several years in which the focus was on deleveraging, the company announced a dividend hike of 5%. The current proposed dividend is 0.2625 CHF, and it represents a 2% yield, with a very safe payout ratio of just less than 33%.

Moreover, the company also initiated a massive buyback program. These programs are a very good sign for recovery. We saw it with the American banks like Citi (C) and Bank of America (BAC), where prior to the massive dividend increases, they started massive buyback plans to lower the number of shares outstanding, which grew when they had to issue shares to get liquidity. The company announced a buyback plan which will reduce the number of shares outstanding by almost 5% in the next 12 months.

Valuation

Due to the rapid growth of the bottom line, and the fact that investors still don't trust CS, the company trades at a much lower valuation compared to its peers. The current P/E ratio is 15, but the forward P/E ratio is extremely low at just 8.5. The company is positioned to deliver additional earnings growth in 2019, and it will probably result in another dividend raise. Together with the current very low P/E ratio, the reward seems adequate.

Chart Data by YCharts

Even when we look at the P/B, we can see how the price declined in the past 12 months despite the better performance. In the meantime, book value went up, and due to that this bank now trades at an extremely low P/B ratio. The current P/B with the growth forecasted for 2019 suggests that the stock is undervalued now.

Chart Data by YCharts

The following graph shows us very well the different valuations for banks. While a bank like Citi already trades close to its book value, the European banks are more depressed. Barclays is affected by the Brexit concerns, and has more room to grow, but it also holds more risks. At the same time, Credit Suisse seems to be on its path to growth, and with less macro concerns, it is more attractively valued. Santander has a similar valuation to CS, but the risks are higher.

Chart Data by YCharts

When I look at the fundamentals and the valuation of Credit Suisse, I am a little surprised. The company grew sales in its profitable segments, doubled earnings in the past three months, delivered a dividend raise and initiated a large buyback program. This package of improving fundamentals comes with a very low valuation when I look at two popular metrics - P/E and P/B.

Leverage

The leverage is the main risk. While the company is still leveraged, it is working on lowering the risks. Right now, it seems safer, and the leverage risk is contained, but it is still fragile and sensitive. Random changes in exchange rates can have a significant impact on the leverage ratio, and therefore it is still a risk even when it seems contained.

On the good side, the company has passed the stress tests conducted by the Fed. The fact that it passed the test is a great sign, and we should take into account the fact that in the future the bank will be subjected to less stress tests since it doesn't have over $250 billion in assets.

The Swiss regulator is also approving the current leverage and liquidity status of Credit Suisse. The current CET1 leverage ratio is 4.1%, while the Swiss 2020 requirement is 3.5%. The company not only has enough capital, but it also improved the ratio in 2018, and therefore it can afford its capital allocation program.

The company will use that excess capital to reward its shareholders with the buyback plan that was announced and dividends. With the CET1 ratio at 12.9%, when the company is willing to maintain above 12%, there is more than enough room for additional buybacks and significant dividend growth.

Restructuring

The main risk is the high leverage and lack of capital, and it seems like Credit Suisse is able to control and improve it and become a safer and less leveraged bank. On the growth side, the company is undergoing a restructuring process that is aimed at limiting risks while focusing on the most profitable business segments such as international banking and wealth management. The company managed to achieve growth in both sectors.

The focus on margins rather than sales is improving the bottom line significantly, and the company has more than enough room to expand its wealth management business. The company focuses on value over volume; it suffers some attrition in sales in other less profitable segments. The overall results are good since income is growing while sales in key segments are growing as well.

The restructuring plan is also improving the return on equity. While the return on tangible equity was only 5.5% in 2018, the company expects to almost double it in 2019 due to its higher profitability. It targets a return on tangible equity of 10-11% in 2019, 11-12% in 2020, and over 12% afterwards. The restructuring plan seems to be on track, and the improvement in profitability metrics will drive earnings and dividends higher.

Conclusion: Credit Suisse's successful restructuring is the key to its performance

The fundamentals of Credit Suisse are strong and have improved immensely over the past several years. The current valuation doesn't take into account the improving fundamentals. The main risk for the company is its risk profile. However, the improved liquidity and lower leverage mitigate this risk. Both Swiss and American regulators believe that the bank is safe, and therefore I believe that this is not a significant risk at the moment.

At the same time, the key driver for growth in the medium-term is the restructuring program. Many times, I am a skeptic when a company promises to achieve growth using restructuring. However, the past three years proved that the management team can execute the plan efficiently. The current plan will lead the company to profitability levels similar to its American peers.

The combination of profitability and ample liquidity will drive the valuation closer to its American peers. Therefore, investors should expect the combination of improving fundamentals due to growth in key segments and improving ROE, and valuation expansion, as the valuation gets closer to its peers.

I still argue that the best way to achieve high returns with less risks from European banks is to build your own small ETF. Banks like Credit Suisse, Barclays and Santander can fit inside together with peers from other countries.

Disclosure: I am/we are long C, BAC. 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.