UBS: This Ain't No Morgan Stanley

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About: UBS Group AG (UBS), Includes: MS
by: Regents Research
Summary

UBS has had a woeful start to 2019 being one of the few financial stocks in Europe that is in negative territory for the year so far.

It has suffered a significant valuation de-rating and is now trading back below net asset value for the first time in several years.

The bull case for UBS has long been that it has at its core a highly profitable wealth management franchise that should command a premium valuation.

However, this story has conspicuously failed to deliver and returns remain much lower than Morgan Stanley, to which UBS is frequently compared. I see little prospect of this changing any time soon and would continue to avoid the shares.

UBS is bottom of the class so far in 2019

Should we be loading up on UBS (NYSE:UBS)? I've had this question frequently from investors over the last couple of months as the share price has detached ever further from European and global peers. Year-to-date UBS is down over 2% against a 15% rally in Credit Suisse (CS) and a 6% bounce in the SX7P European banking index. Morgan Stanley (MS) is up 13%.

UBS is amongst the weakest performers of peers year-to-date

Source: FT markets data

On the face of it, this looks a great time to buy in. UBS has been regarded as a compelling story for several years as the investment bank has been culled and the company's core wealth management businesses have gained ever greater prominence within the group. In theory, this shifting mix of businesses out of volatile, low multiple trading activities and into annuity-style, high multiple asset gathering should deliver a re-rating of the shares over time. Only that hasn't happened.

The performance recently has undoubtedly been negatively impacted by extraneous issues that could perhaps be dismissed as legacy or at least not related to the core business mix thesis. Specifically, confidence has taken a knock from the announcement in February that UBS had been found guilty by a French court of illegally soliciting clients and laundering the proceeds of tax fraud. The company has been fined an eye-watering €4.5bn, which it is appealing. However, the fact that the company's total provisions for all litigation cases are only $2.7bn (€2.4bn) means there is a potentially significant liability here.

1Q results were also uninspiring, with the investment bank posting a big decline in profits (FT write-up here).

However, I think the problems at UBS run deeper than this.

Profitability is the real problem

Ultimately, it all comes down to return on equity and the blunt fact is that however nice the UBS wealth management story is on paper, it simply hasn't delivered the level of improvement to group returns that are necessary to substantially re-rate the shares.

The comparison to Morgan Stanley is instructive since both companies have very similar strategies based on re-focussing on wealth, downsizing investment banking, and drastically reducing balance sheet exposure to their sub-scale fixed income businesses.

The chart below compares the return on tangible equity experience of both firms (at group level) in recent years. It serves to highlight that UBS has made virtually no progress since 2014 over a period where Morgan Stanley has increased ROTE by two-and-a-half times.

UBS versus Morgan Stanley

Source: company accounts

As of 1Q19, Morgan Stanley's ROTE stood at 14.9% against UBS on just 9.8%. This is a c.50% differential, which directly explains why UBS is trading on 0.9x price to net assets and Morgan Stanley on 1.1x. Indeed, the real surprise is not that UBS is at a discount, but that the discount isn't actually larger. Clearly, the market continues to hold out some hope that the gap can be narrowed.

Lacklustre profitability has spawned other problems

UBS's inability to improve its mediocre return on equity has spawned other problems that have further weighed on its valuation.

First, it has meant that the pace at which UBS has been able to increase its regulatory capital position has been slower than hoped for. The key regulatory capital ratio (core equity tier 1) stood at 13.0% in 1Q19, which is actually lower than it was in 2014 (albeit there have been various changes to the way the ratio is calculated since then; UBS says that on 2014 rules, the current ratio would be closer to 16%).

Nevertheless, the comparison to Morgan Stanley is again unflattering since Morgan Stanley has increased core tier 1 from 12.6% to 16.5% over the same period.

Capital remains a significant headwind for UBS since it is hard to advertise yourself as a fortress for the wealth of high net worth individuals if your regulatory ratios are adrift of peers and in decline.

Source: company accounts

The second problem is that UBS's poor profitability has spawned is an inability to scale up payouts to shareholders to levels that might have been anticipated from its supposedly cash generative wealth business. UBS started its first share buyback only in 2018, repurchasing $762m worth of shares. It is targeting $1bn this year.

But, this is a paltry amount compared to the $4.9bn of stock that Morgan Stanley repurchased in 2018 and the $4.7bn it has been authorised by the Fed to repurchase this year.

Looking back to 2014, Morgan Stanley has paid out a total of $20bn in dividends and buyback to its shareholders. UBS has paid out just $11bn. The chart below also shows that anticipated payouts from UBS in 2019 (calculated from consensus dividend estimates and the company's guidance on buybacks) will be just 16% higher than their level in 2015 whereas likely payouts for Morgan Stanley (again consensus dividends plus the buyback authorisation) will be 2x higher than 2015.

Source: company accounts

UBS faces structural challenges in wealth management

Why has UBS been unable to boost its return on equity?

There are several angles to this. An important one is that the Swiss regulator has demanded even more capital, this being the big drawback of being domiciled in a relatively small country. UBS had shareholders' equity of $36bn on the eve of the GFC in 2007 and $2.2tn of assets. Today, it has $57bn of equity supporting assets of only $1tn. It has struggled to remunerate this ever-increasing capital base.

However, the bigger long-term problem I see is the declining profitability of UBS's wealth franchise that was supposed to be the cash cow. Pre-tax margins in this business have been on a downward trend for years, but the recent slide has become more pronounced, and as of 1Q19, UBS finds itself materially below Morgan Stanley on this key metric, as the next chart shows.

Source: company accounts

This is driving lower return on equity in Wealth, which fell to 21% in 1Q19 from over 27% in 1Q18. It is still well above the group average, so the business mix shift story hasn't disappeared entirely. But Wealth doesn't look like the golden goose it once was.

The key reason for this is the structural decline in UBS's traditional stronghold of offshore wealth, especially Switzerland. Here, years of heightened tax scrutiny, KYC demands, and automatic exchange of information protocols with other tax jurisdictions have significantly dented the appeal of offshore banking for many clients. With most of UBS's new wealth inflows coming from low margin Asia, this structural downshift in the overall profitability of the wealth business probably still has some way to run.

Conclusions

Until recently, UBS seemed to have an investment story that elevated it out of the morass of European banking, built on its profitable global wealth management business and relative absence of exposure to low growth eurozone economies.

This bubble has burst with the stock's recent slide back below net asset value. It is now no more highly valued than eurozone commercial banking peers like ING (ING) or Intesa Sanpaolo (OTCPK:IITOF).

With return on equity in decline and with little improvement in sight (consensus estimates see UBS posting ROE of just 9.6% this year and 10.3% next year), I can't see UBS resurrecting itself any time soon. The risk is that if investors throw the towel in on the idea of this being the next Morgan Stanley, we could be in for an extended period of share price disappointment.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.