Increasing eurozone concerns, stressed market conditions as well as loss associated with the glitches of the Facebook Inc. (FB) initial public offering at the Nasdaq OMX Group Inc. (NDAQ) led a to drop in profits at UBS AG (UBS). The outlook is also bleak.

The company reported second quarter net profit attributable to shareholders of CHF 425 million ($434 million) or CHF 0.11 per share, down from CHF 827 million or CHF 0.22 per share in the prior quarter. Earnings also fell short of CHF 1.0 billion or CHF 0.26 per share reported in the prior-year quarter.

The quarter’s results at UBS AG were impacted by a decrease in trading revenues as well as a decline in net fee and commission income. Operating expenses were also higher in the quarter. However, an own credit gain partly mitigated these declines. Operating income fell 2% from the prior quarter to CHF 6,408 million while operating expenses escalated 5% sequentially CHF 5,457 million.

UBS AG experienced a 27% sequential decrease in operating profit before tax to CHF 951 million. Its Investment Bank division incurred a pre-tax loss of CHF 130 million in the reported quarter compared with a pre-tax profit of CHF 730 million in the prior quarter, reflecting substantial drop in revenues in its securities business in the backdrop of challenging market conditions. Moreover, it suffered a loss of CHF 349 million associated with the glitches in the Facebook debut. The company plans to take legal action against NASDAQ over this issue.

Investment Banking division’s total revenue dropped 6% sequentially due to reduction in fees which was partially offset by lower risk management premiums. With declines across most of its businesses, Equities revenues fell 75%. Moreover, increasing eurozone concerns as well as tepid growth in the US resulted in challenging market conditions and therefore, fixed income, currencies and commodities revenue decreased 27% from the prior quarter.

Besides reporting a loss in the Investment Bank division, UBS AG experienced a 37% sequential decrease in operating profit before tax to CHF 502 million in the Wealth Management division. Retail and Corporate division’s operating profit before tax declined 31% from the prior quarter to CHF 399 million. Though that of Wealth Management Americas moved up 5% from the prior quarter to CHF 200 million, Global Asset Management’s profit fell 24% sequentially to CHF 118 million.

UBS AG’s invested assets were CHF 2,163 billion as of June 30, 2012, up from CHF 2,115 billion as of March 31, 2012. The company saw an increase in regulatory capital. Its Basel 2.5 tier 1 capital increased by CHF 1.6 billion during the second quarter aided by lower tier 1 deductions, currency effects and net profit. Basel 2.5 tier 1 capital ratio stood at 19.2% on June 30, 2012, up 50 basis points sequentially. As of June 30, 2012, balance sheet assets stood at CHF 1,412 billion, CHF 46 billion higher than on March 31, 2012.

Outlook

The outlook seems grim with UBS AG predicting no material improvement in market conditions in the third quarter of 2012. Progress on sustained and material improvements to the ongoing eurozone sovereign debt concerns, the European banking system and US federal budget deficit issues, and the uncertainty at large could impact the client activity levels in the third quarter.

Therefore, failure to make progress on these issues in addition to the reduction in market activity levels typically witnessed in the third quarter would likely result in headwinds to revenue growth, net interest margins and net new money at UBS AG.

Yet, UBS AG expects its wealth management businesses to continue to attract net new money. The company also remains on track to achieve its cost savings targets by the end of 2013. Moreover, it is committed to strengthen its capital position and lower its Basel III risk-weighted assets and expects its Basel III tier 1 ratio to be above 9% by the end of 2012.

Our Take

We believe that the volatile capital market conditions will restrict top-line growth at UBS AG. However, in the midst of the overall economic volatility and the eurozone debt crisis, the company will focus on building its capital level. Restructuring initiatives are encouraging and we believe that such efforts would help improve its operating efficiency in the years ahead.

Deutsche Bank AG (DB), one of UBS AG’s rivals, has also posted discouraging second quarter results. The company, which reported its complete result today, came up with a preliminary update on its second quarter results last week.

Deutsche Bank’s net income attributable to its shareholders for the quarter came at EUR650 million ($798 million), significantly down from EUR1.2 billion in the prior-year quarter, reflecting the impact of the European sovereign debt crisis on investor confidence and client activity across the bank. A weak Euro also affected its expense base.

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