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Stock Strategist

Credit Suisse's Quality Comes to the Fore

We don't think the market appreciates the significant derisking that has taken place.

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 Credit Suisse (CS) reported net profit of CHF 749 billion for the first quarter of 2019, which is 8% higher than the first quarter of 2018 and 11% higher than consensus expectations. However, the increase was solely the result of a lower tax rate; pretax profit of CHF 1.1 billion was stable compared with the first quarter of 2018. We expect a full-year pretax profit increase of 39%, which may look a bit rich considering the flat first quarter. However, we point out that the first quarter of 2018 contributed 31% of pretax profit and the first half of 2018 accounted for 62% of pretax profit. We maintain our narrow moat rating and fair value estimate and believe the shares are undervalued.

Group revenue declined 4% year over year as primary market activities in the investment bank collapsed; equity underwriting and debt underwriting declined 44% and 27%, respectively, year on year. Management did indicate that there is a substantial pipeline of deals that should support future revenue growth.

The key wealth management banking businesses did see a revenue decline of 3% year on year, but given market weakness and a flattening yield curve, we view this as a robust result. Most pleasingly, the wealth management businesses recorded a net new money inflow of CHF 10 billion for the first quarter of 2019. Despite buying back CHF 261 million of shares, Credit Suisse managed to maintain its common equity Tier 1 ratio at 12.6%.

We continue to believe that 2019 will be the first relatively clean fiscal year for the better part of a decade, with earnings free of distortions from noncore portfolios in rundown. This should confirm the solid profitability of Credit Suisse’s underlying business to the market. We also believe that the market has to date not acknowledged the significant derisking that has taken place at Credit Suisse. Compared with a few years ago, Credit Suisse relies much less on volatile trading revenue and is on much sounder capital footing.

True Profitability Has Been Hidden
The profitability of Credit Suisse’s core businesses comfortably exceeds its cost of capital; we estimate a midcycle return on equity of 12% compared with our cost of capital estimate of 10%. A few issues have concealed the company’s true profitability. As part of the process of derisking the business away from volatile sales and trading, Credit Suisse has run down a massive noncore book of EUR 130 billion to EUR 20 billion since 2015, incurring cumulative before-tax losses of EUR 15 billion in the process. To add insult to injury, Credit Suisse has incurred legal expenses of CHF 7 billion over the past four years.

Credit Suisse has often been criticized that it was behind UBS (UBS) in adapting its strategy to the new requirements for Swiss private banks. The market has hounded Credit Suisse to reduce its exposure to risky sales and trading and replicate UBS’ business mix, where wealth management dominates. However, there are many more similarities between Credit Suisse and UBS than there are differences. We believe that losses booked out of the noncore portfolio have led investors to overestimate the importance of sales and trading to Credit Suisse.

Wealth Management Provides a Moat
We believe Credit Suisse deserves a narrow moat for its wealth management business. We find moats for intangible assets and switching costs. In wealth management, a moat for intangible assets is built on a firm’s reputation, specialized expertise, and scope of services. We also believe that the complexity of client needs supports wider moats. The needs of clients become more complex as one moves up the wealth pyramid.

Credit Suisse emerged as one of the stronger banks after the 2008 financial crisis and did not need a government bailout. Its reputation did suffer from the tax evasion investigation and subsequent fines levied by the U.S. authorities, however. While a well-known and respected brand is important to attract clients, it is an equally important consideration for incumbent and prospective bankers and relationship managers. Credit Suisse was rated the third-best private bank globally by its peers in the 2017 Euromoney awards and was rated very highly in the key growth markets of the Middle East (first) and Asia (second).

After the 2009 crisis, the importance of capital adequacy to a bank’s reputation has increased. This is illustrated by the significant outflows UBS experienced from its wealth management business when there were concerns surrounding the bank’s level of capital. Credit Suisse has one of the highest core Tier 1 equity ratios in Europe, but its leverage ratio has been problematic, even more so than main rival UBS’, given Credit Suisse’s historical focus on fixed-income trading.

We believe that complexity supports moats in wealth management and that ultra-high-net-worth individuals and family offices are a much more moaty business than the mass affluent market. Ultra-high-net-worth individuals and family offices have needs that are as complex as those of institutional investors, if not more so. They may need access to structured financing, generational wealth planning, family office support, and international tax planning across multiple geographies. They also tend to have much more complex portfolios, often including family businesses, real estate, hedge funds, and other illiquid assets. These issues are typically outside the ability of advisors at lower-tier firms. Hiring professionals to address these issues is not cheap, and only a relative handful of companies have enough ultra-rich clients to make the cost worth their while. Many have international holdings, which increases the complexity of compliance with anti-money laundering, know-your-customer, tax reporting, and other regulations. Credit Suisse confirms our view; at a recent investor day, it showed that typical returns on risk adjusted capital in its ultra-high-net-worth segment exceed 30%, while returns in the mass affluent market vary between 10% and 15%.

Ultra-high-net-worth clients value strong relationships with their bankers, typically built up over years, often across generations. We believe that Credit Suisse’s client base faces high switching costs. Typically for wealth managers and commercial banks, we believe that switching costs are mostly implicit and include losing a valued relationship with the incumbent advisor, the time necessary to find and vet a new advisor and/or firm, the paperwork involved in moving accounts, and the mental energy needed to choose and approve new investment vehicles.

These switching costs are all true for Credit Suisse as well, but we believe the company’s book with its significant portion of ultra-high-net-worth individuals faces even higher switching costs. It will have deep relationships with its clients spanning various investment, transactional, and lending products--often integrated--which makes pricing opaque. Products are often tailor-made to the client’s needs so it is impossible for a client to easily compare pricing. The daunting prospect of untangling the web of products that a client has with a bank is often enough to prevent the client from moving to a competitor.

Private bank clients will typically not only have investment products with their bank. The distinction between a private bank and a wealth manager is blurry and often overlooked. We believe it is important. A private bank that offers its clients transactional and lending products raises switching costs compared with wealth management businesses that only offer investment products.

We believe that having an in-house investment bank improves the ability to provide complex solutions to ultra-high-net-worth clients. These individuals are also often entrepreneurs who have banking needs in their business capacity in addition to their personal needs. The ability to service the client’s business as well as personal needs is a major competitive advantage. However, an investment bank is much more capital-hungry than a pure private bank and introduces added risks that may detract from a bank’s reputation for solidity. In the case of UBS, its investment banking adventures nearly led to the bank’s demise.

Swiss Banking Environment Attractive
An evaluation of the banking system that a bank operates in is critical for us to have a high level of conviction in the moats we find for an individual bank. We define a banking system in broader terms, than merely the regulatory environment in a particular jurisdiction. Competitive, political, and economic elements also contribute to the robustness of a system to withstand banking crises. Overall, we assign ratings to banking systems into four buckets: very good, good, fair, and poor. We view the Swiss banking system as very good, the only European country that we accord this rating. Globally, it is only the Australian and Canadian banking systems that we view equally positively.

The Swiss regulatory environment is exceptionally strong, and the Swiss National Bank’s requirements often exceed those of the Basel accord and the European Banking Authority. Switzerland is one of the world’s most stable democracies and its devolved, cantonal system of government limits the potential of populist extremist parties.

Competition in Switzerland is also less intense and more rational than in most other European jurisdictions. UBS and Credit Suisse dominate the Swiss banking sector, holding 50% of all Swiss banking assets. Partially state-owned cantonal banks and mutually owned Raiffeisen account for 25% of Swiss banking assets, but we believe that in contrast to some other jurisdictions in Europe, the cantonal banks are much more rational in pricing and there is a desire to cover cost of capital; in fact the cantonal banks are more profitable than the pure commercial banks.

Switzerland has a long history as the banker to the world, and 25% of cross-border assets around the world are managed there. Historically, Swiss banking was best known for its fabled numbered of anonymous accounts--the numbered account and indeed any amount of privacy over financial matters. The global consensus seems to be that the right of the majority to have unfettered access to data trumps the right of privacy of the individual. The U.S. clampdown on offshore tax structures and antiterrorism measures further eroded the Swiss reputation for guardians of financial information.

The bailout of UBS by the Swiss government in 2009 did damage to the popular image of the inviolable stability of Swiss banks. However, we believe that Swiss banks remain attractive to the world’s elite for two main reasons: first, Swiss neutrality and second, the Swiss franc.

Both factors speak to downside protection and safeguarding of wealth. Switzerland has been neutral since 1815 and escaped the ravages of both world wars. Switzerland is also not aligned to any power bloc; it is not an EU member nor is it a member of NATO. Even for wealthy citizens of stable democracies in the rest of Europe or North America, Switzerland represents a safe haven that provides diversification and liquidity to their portfolios. The Swiss franc has long been seen as an alternative for gold. During the 2008 and 2011 financial crises, the franc appreciated against both the U.S. dollar and the euro, illustrating this concept. The removal of the franc’s peg against the euro in 2015 enhanced the attraction of the franc as portfolio diversification tool to minimize risk. The franc also serves as protection against any debasement of other major currencies by loose monetary policies.

Market Risk Still Exists
Credit Suisse retains meaningful exposure to market risk despite scaling back and derisking its investment banking activities. Apart from trading, Credit Suisse’s wealth management and asset management revenues are linked to the market, with fees based on assets under management; also, performance fees are more likely to occur in bull than bear markets. Traditional market risk measurements also do not capture the impact of declining markets on client behavior, where lower client risk appetite typically lead to lower new business inflows. The extreme volatility of the postcrisis years is likely to be a thing of the past, however.

Revenue denominated in U.S. dollars makes up 49% of Credit Suisse’s overall revenue, yet dollar-denominated costs contribute only 34% to total costs. Credit Suisse is thus positively correlated to a weak Swiss franc. Credit Suisse estimates that a strengthening of 10% of the franc/dollar will lead to a decline of pretax earnings of CHF 468 million, which we estimate is around 11% of normalized pretax earnings.

Net interest income makes up 30% of overall revenue, which is a lower portion than one would find at a typical universal bank. In its 2016 risk disclosure, Credit Suisse indicates that a 1% parallel shift in the yield curve will lead to a CHF 500 million change in profits before tax (we estimate this equates to 11% of normalized profits before tax).

Credit Suisse has one of the lowest exposures to credit risk in our European coverage universe. On-balance-sheet lending is not an important part of the overall business model; loans make up only 35% of the balance sheet, and 80% of loans are granted to clients of the Swiss universal bank or wealth management clients. We view these as very high-quality exposures. In addition, 75% of all credit exposures are secured by collateral.

If one looks at Credit Suisse’s core equity Tier 1 ratio of 12.8%, it seems to be comfortably capitalized; however, its leverage ratio of 3.8% is very close to the minimum 3.5% required by the Swiss National Bank. We are a bit puzzled as to why Credit Suisse did not raise more capital to create a more comfortable buffer when it made its capital call in 2017.

Both Credit Suisse’s liquidity coverage ratio and its net stable funding ratio are comfortably above 100%, which indicates sound liquidity. To our mind, these ratios, while helpful, do not fully capture the quality of a bank’s funding. One should also consider the structure of a bank’s funding--where the relatively lower importance of wholesale deposits in Credit Suisse’s funding mix is a clear positive. However, private banking/wealth management clients will typically be more sophisticated than the average retail banking client and therefore more likely to withdraw funds in times of stress. We therefore do not believe that private banking deposits are as sticky as general retail deposits, although they remain more sticky than wholesale funding.

Johann Scholtz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.