Revisiting HBSC Puts: Downside Rationale Still Exists

As the market ticks like a little time bomb here, we're going to revisit one of our March 2008 recommendations to buy HBSC (HBC) June 75 puts (HSBC Holdings: The Bigger They Are, the Harder They Fall).  Those puts expired worthless on Friday, but the stock is right where it was back in March, and we think the rationale for a downside put play on this name still exists.  Once more into the breach, comrades.

HSBC Holdings, PLC (HBC) is a United Kingdom-based banking and financial services organization.  Its international network comprises over 10,000 branches in 82 countries and territories. The headquarters is in London.  HSBC provides a full range of financial services to more than 125 million customers.  HSBC has recently been on a buying spree, acquiring banks in South Africa, Argentina, and Australia.  In 2003, HSBC also bought Household Finance, which was a market leader in credit card and home equity loans in the U.S.

Subsequent to that acquisition, HSBC has had to close the mortgage origination division of Household, and take several multi-billion dollar charges against earnings for the losses stemming from that acquisition.  HSBC was an early mover in bringing liabilities and assets that resided in off-balance sheet structured investment vehicles ("SIV's").  That sort of an action at the time was a bold move.  Unfortunately, we think that move will eventually impact the bottom line of HBC - more negatively than it has to date - with a dollar number that could measure in the billions. There is massive consumer debt exposure here that could also impact the shares negatively.

As we have all been reading, foreclosures and delinquencies have surged in recent months, particularly among homeowners who took out high-risk mortgages.  The distress has forced several mortgage lenders into bankruptcy and stoked anxiety that the problems are now spilling over into the broader economy.  As these impairments to value continue, banks are taking multi-billion dollar charges for their mortgage backed bonds, SIV’s and consumer (credit card related) debts.  We see the potential for a significant negative impact to HBC’s earnings and / or equity value here from exactly those vehicles.

HBC is heavily exposed to credit card assets.  In that light it is similar to Capital One (COF), which earlier this year slashed its earnings estimates by over 20% due to higher default rates and building losses.  We see potential for a negative impact to HBC's earnings from this exposure as well.  In this situation and in this credit climate, the risks are not necessarily outweighing the rewards.  We still feel a put spread presents a compelling opportunity.

Technical Analysis 

The chart above shows HBC for the last six months. The stock has bucked the trend in financials over the last few months, meaning it hasn't gone straight down.  The Relative Strength Index [RSI] and Moving Average Convergence / Divergence [MACD] stochastic lines are both negative right now, reflecting weakness in teh support for this company's shares on a technical basis.      

Fundamental Data

• Current Price:  $79.06
• Shares Outstanding: 11.8 billion
• Market Cap: HK $1.7 trillion
• Forward Price / Earnings (avg. Est): N/A
• PEG Ratio (5 Year Expected):  N/A
• Price / Book:  N/A

As a foreign corporation, HBC's estimates for earnings are expressed in only annual increments.  The published 2008 annual earnings estimates for HBC are averaging about $7.25 per ADR for the full year ending in December, versus a 2007 figure of $8.25 per share.  2009's earnings estimates are currently posted at $8.70 per ADR.  

The 3 analysts covering the company don't seem to be in agreement as to the actual number though, as high estimates for HBC in 2008 are at $9.00 per ADR, and the low estimate is at $6.00 per ADR.  There's not much transparency here in terms of looking down the road for clues to the company's results, so take those estimated averages with a grain of salt.

Despite the wideness of these estimates, the average ADR earnings estimates have been slowly deflating over the past 60 days, from a 2008 level of $7.80 per ADR on average to the present $7.25 per ADR.  The recent high point in terms of stock valuation for HBC was back in November of 2007 when the company's ADR's peaked at nearly $100.  Since then, the shares have posted a low of just below $70 in February of 2008.

The HBC balance sheet was used in early 2008 to bring collection of off-balance sheet SIV's, or structured investment vehicles, onto the parent company's books.  This allowed the bank to support those SIV's directly, rather than have a high-profile liquidation or 'credit event' that could have followed.  Many analysts give the company high marks for that move, which many of the other banks like Citi and even Bear Stearns have subsequently followed.  We think there is more credit card, SIV and sub-prime mortgage exposure here on the HBC balance sheet than is currently being revealed.  HBC is not subject to the same scrutiny as US-based banks, and this could, in our opinion, be a firewall behind which some credit detioriation may be happening that is unseen or appreciated fully in the ADR price.  The purchase of Household Finance by HBC back in 2003 gave them a tremendous position in all of those US credit markets, and we don't believe we've seen all the write-offs related to that investment yet.

To the positive, HBC has a globally diversified base of business.  It's very strong in the Asian markets where growth remains healthy.  HBC has been mentioned repeatedly as one of the possible buyers for Lehman Brothers (LEH), although the speculative scope of the impact that might have on HBC shares is beyond the scope of this report; we don't particularly think that buying LEH would be a major positive for HBC in the immediate future.  They would have their corporate hands full of a whole new set of credit problems if that acquisition were to come to pass.

Investment Recommendation

Our recommendation this week is to buy an HBC put spread.  We are recommending buying an HBC January 2009 $75.00 put for $4.30, and writing the January 2009 $65 puts for $1.70, for a net cost of $2.60 to this spread.  We would look to sell this put spread at a level of $8.00 or higher between now and the future expiration, giving us a return of just over triple the money.

We've heard from a few of our readers who just want straight option buy recommendations, rather than spreads.  For investors who do not wish to write the lower strike priced put, a direct purchase of the January $75 put for $4.30 would be an alternative.  We would look to sell that put at a level of $10.00 or higher.  We would specifically look to sell that put option when and if the company announces a significant credit reserve or write-off that impacts its earnings.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

Disclosure: Analyst has no position in HBC stock or HBC options.

 

Comments

[Navivest]

From $79, there might be some downside, but those initiating the trade and buying the $75 puts should look to take early profits. Don't buy on the expectation that the stock would crash because of the crisis facing financial companies right now.

A move of about one point to the downside over the next week will yield double digit gains. Get out then.

Another word of caution, needless to say, the financials would be the most affected with the news from the fed policy meeting tomorrow. It might be prudent to wait until after that, before entering the trade.