It is rather uncommon to find bargains among blue chip companies, especially at the time of general overvaluation in the markets. However, I believe HSBC (NYSE:HSBC) to be such a stock. My investment thesis can be summarized in several points, on which I will elaborate in this article:
- 5% dividend yield that continues to grow 10% annually;
- Exposure to trade growth in emerging markets, especially Asia - a long-term tailwind for the company;
- Management is shareholder-oriented, delivers on its promises and allocates capital efficiently;
- HSBC is well-capitalized (Tier 1 - 13.6%);
- HSBC is profitable, with ROE 9.2% and with a target ROE of 12%-15% (to be achieved in a couple of years);
- HSBC is cheap, trading at book value with P/E=11.
High dividend yield
HSBC currently yields 5%, and has grown the dividend for the last 4 years by 10%. This compares to a 2.5% dividend yield for both Wells Fargo (NYSE:WFC) and JPMorgan (NYSE:JPM). Thus, with current levels of overvaluation in the markets, it might be worthwhile holding on to a world-class bank that yields twice as much as its peers.
The current dividend payout ratio is 57%, with the rest retained in the business. This not only provides capital further growth opportunities (unlike businesses which pay out most of their earnings), but also leaves a possibility of further increases in dividends if growth opportunities are not available. It is also worth noting that capital generated by non-core asset disposals was so far used to boost capital ratios, but with HSBC now well-capitalized, the generated spare capital can be used for dividend payouts or share buybacks.
Prudent management in place
Investing in banks requires huge trust in management. There is no transparency on what really hides behind 500+ pages of annual reports, and there is no way for outsiders to judge how profitable certain investments will be. HSBC management stands out as being shareholder-oriented (the dividend yield I mentioned above) and delivering on its promises. Back in 2011, a strategic transformation plan was announced, which mainly focused on disposals/closures of underperforming businesses and aimed to achieve c. $3bn of sustainable cost savings. Within 2 years, RWAs were reduced by c. 8%, number of employees decreased by 20%, and annualized sustainable cost savings of $5bn were achieved. And all of this was carried out while increasing bottom line profitability. Management plans further business transformation through 2014-2016, transparently communicating target KPIs to shareholders. Thus, HSBC management not only speaks of reaching ROEs 12%-15%, but communicates a clear plan how this level of profitability will be reached.
Exposure to emerging markets and trade flows
HSBC currently generates 90% of its profit from emerging markets (75% from Asia). So, even though perspectives for US housing market (and in turn banks like WFC and BofA (NYSE:BAC), that rely on it) are bright for upcoming years, long-term growth perspectives are likely to be much better for emerging markets. Moreover, HSBC is exposed not only to the GDP growth of emerging markets, but it is also best positioned among global banks to capture international trade and capital flows. I believe this chart (although a bit outdated) clearly illustrates the point - trade growth has significantly outpaced GDP growth over the last 30 years and will continue to accelerate as the world gets more interconnected. HSBC, with its slogan "World's local bank" and network covering majority of the trading routes, is well-placed to capture these trends.
HSBC is well-capitalized
High leverage is the main problem of investing in European banks following the crisis (equity/assets) e.g., Deutsche Bank (NYSE:DB) has leverage of 3.1%, Barclays (NYSE:BCS) of 3.3%, Credit Suisse (NYSE:CS) of 5%. A recent article in The Economist noted that 75% of large European banks have leverage at or below 3%. Thus, a small change in asset value can wipe out the whole equity completely. European leverage compares rather unfavorably with the largest American banks, which promptly carried out significant recapitalization and non-core asset disposal programs. The average leverage among large American banks - Bank of America, Wells Fargo, JPMorgan, and Citi (NYSE:C) - is 10%.
When it comes HSBC, most investors view it as a European bank, however, it stands out as having twice better leverage (7.1%) than its European counterparts. Moreover, its Tier 1 ratio of 13.6% is in line with its American peers (which are considered well-capitalized).
Looking at the funding side, deposits (which is a cheap funding source) make up 60% of the assets, again in line with American peers. The same goes for Loan/Deposit ratio of 73%, the average for the 4 indicated American banks is 71%.
HSBC's profitability is growing
For 2013, HSBC achieved ROE of 9.2% compared to 8.4% in 2012. Management is aiming to achieve ROE of 12%-15%. Looking historically, average ROE was 15%-16% pre crisis, declined to 6% during 2008-2009, and then continued to grow since. Cost-efficiency already stands at 59%, with management's target of 50%. These targets look achievable within the next couple of years as management continues with its transformation program and disposes of non-core assets. Further sustainable cost savings of $2-$3bn (or 15% of 2013 net profit) are planned for 2014-2016.
Moreover, currently European business is a bit of a drag on HSBC's profitability. ROA of European business stands at 0.1%, whereas other businesses in Asia and Emerging markets average 1.3% (European business uses 50% of the assets, but generates only 8% of net profit). As the transformation program continues, further improvements in European profitability (or disposal of assets) are likely, and this will have a material impact on HSBC's bottom line.
HSBC is cheap
I left the juiciest point for the end. HSBC currently trades at a book value which is in line with its American and European counterparts (with some variation depending on the perceived stability and quality of operations). However, as mentioned above, 90% of HSBC's profit is generated in emerging markets, which should convey higher valuation (among growing Asian banks, 1.5x tangible book value is considered cheap, e.g. ICICI (NYSE:IBN)). At the same time, companies with exposure to higher growth markets/industries tend to command P/Es of c. 20+, whereas HSBS currently sells for only P/E=11. Thus, a potential 50% upside seems to be a rather conservative estimate.
Another way to look at this is through management's forecasts of HSBC's profitability (as detailed above, management tends to over-deliver on its promises). Let's assume ROE target mid-point of 13.5% will be reached in the next two years, with the following results for 2014-2015:
2014 - ROE=11%, Net profit $21bn, out of which 50% retained, resulting in BV of $200bn and dividends of $10.5bn.
2015 - ROE=13.5%, Net profit $27bn, out of which 50% retained, resulting in BV of $213bn and dividends of $13.5bn.
Thus, within two years, HSBC could distribute $24bn in dividends and generate additional $24bn of book value. Then, with ROE=13.5%, it would easily trade at P/BV=1.35 (for comparison, WFC trades at 1.4xBV with ROE of 13%). Thus, at the end of 2015, market cap would be $287bn. Adding $25bn of distributed dividends, the total realized investor return becomes 57% (using current market cap of $195bn for value of initial investment).
Obviously, it might take a bit longer than two years for management to reach the projected 12%-15% of ROE, but with high exposure to growth in global trade flows and emerging market GDP, it is a question of when rather than if. And even if it takes a bit longer (keep in mind that HSBC's management tends to over-deliver), 5% and growing dividend return more than compensates for the waiting.