HSBC Should Be A Core Bank Holding

HSBC Holdings Corp (HBC) is one of the largest global banks with substantial operations in all major regions. Founded in 1865 and formally known as Hong Kong and Shanghai Bank Corp, HBC services about 60 million retail customers from 6900 offices in 85 countries. Just prior to the expiration of the 99-year lease of Hong Kong and the "Handover" by Britain to China in 1997, HBC moved its headquarters from Hong Kong to London, and the domicile country changed to the UK. HBC ADRs trade on the NYSE with a ratio of one ADR equals five shares traded on the London Exchange.

HBC is organized using the following six geographical regions and each region's percentage of 2011 pretax profits and assets:

Asia-Pacific Ex-Hong Kong - 34.2% of profits and 12% of assets

Hong Kong - 26.6% of profits and 18% of assets

Europe - 21.4% of profits and 47% of assets

Latin America - 10.6% of profits and 4% of assets

Middle East - 6.8% of profits and 2% of assets

North America - 0.5% of profits and 17% of assets

In each region, clients are categorized into the following four segments and each segment's percentage of 2011 pretax profits: Commercial Banking 36%, Global Banking and Markets 32%, Retail Bank & Wealth Management 20%, Global Private Banking 4%.

HBC has historically been focused on the Asian markets as their strength. However in the 80s and 90s management desired to expand its footprint, going on an acquisition spree in Europe and the US. One ill-fated acquisition was HBC's purchase of Household Finance in 2002. During the financial crisis, Household Finance became a real problem with its sub-prime mortgage exposure. Late in 2007, management announced a multi-year restructuring to return to the company's strength - Asia and developing countries.

In 2011, management offered another restructuring plan with the following goal, from their website:

Our strategy is based on two major trends: the continuing growth of international trade and capital flows; and wealth creation, particularly in faster-growing markets. We are capitalizing on these trends, connecting customers to opportunities by building on our distinctive presence in the network of markets, capturing wealth creation in target markets and focusing on retail banking only where we can achieve profitable scale.

Since the start of 2011, HBC has shed 39 non-core asset. For example, in mid-2012, HBC sold its US credit card business to Capital One Financial (COF) for $31.1 billion including a $2.5 billion premium. The goal of the restructuring will be to continue to sell US and European assets in favor of higher Asian and Latin American exposure. Through the middle of 2012, management has sold over $55 billion in risk-weighted assets. In 2011, management also targeted $2.5 to $3.5 billion in overhead savings, and claims to have reached the $2.0 billion level within the first year. More information can be found in their May 2012 Investors Day information found here.

A huge goal of the 2011 restructuring is to increase return on equity to the 12% to 15% range. While aggressive, it seems the low end will be reached this year. Along with an increase in ROE comes the goal of a reduction in operating efficiency to 48% to 52%. This important ratio simplifies for shareholders how much of income is being sucked out for operations. The formula for calculating the efficiency ratio is: Total Non-Interest Expense as a percentage of Net Interest Income + Non-Interest Income. Below is a table of trailing 12 month bank efficiency ratio, per the website bankregdata.com:

Institution	Symb	Ratio %
JPMorgan Chase & Co.	JPM	69.43
Bank of America Corporation	BAC	60.95
Wells Fargo & Company	WFC	54.15
Citigroup	C	68.74
U.S. Bancorp	USB	52.89
Capital One Financial Corporation	COF	61.19
Bank of New York Mellon Corporation	BK	79.46
PNC Bank	PNC	70.68
Toronto-Dominion Bank	TD	72.06
State Street Bank and Trust Company	STT	76.85
HSBC Holdings PLC (from 2012 annual report dated 3/4/2013)	HBC	63.90

Click to enlarge

To put this table in perspective, below are two graphs depicting efficiency ratios for the sector for the past 12 quarters and the past 10 years, also from bankregdata.com:

Quarterly

10-Year

HBC recently announced 4th quarter and full year 2012 earnings results. While they were down from 2011, the reduction is based on non-cash and one-time charges. From the Zacks report on earnings:

In 2012, net profit came in at $14.0 billion, plummeting 16.5% from $16.8 billion in 2011. The primary reason for the year-over-year fall in earnings was a $9.1 billion negative swing in the fair value of own debt as credit spreads tightened and a higher tax rate.

In addition to announcing earnings, management updated investors on its regional performance. While developed countries lagged due to the headwinds of legacy issues and slow economic growth, emerging markets reported stronger results. For example, Hong Kong underlying profits grew by 24% and earned a ROE of 6.6%, up from 5.3% in 2011. Also, management announced its capital base continued to expand and should meet the fully loaded Basel III ratio of 10.3 by the end of this year.

More information is contained in HBC press release for year-end results here and from Zacks here.

HBC is establishing itself as a worthy competitor in the faster growth areas of Asia and Latin America. This is where the growth in the financial sector will be realized over the next few years. While US financial institutions continue to rework their assets after the financial mess of 2008 and the European banks a re preoccupied with their current problems, HBC's efforts seems to be directed towards longer-term business growth. In addition, as the majority of its assets are not in the US and Europe, these crisis regions continues to hammer HBC's competitors and HBC fared a bit better.

On the other side, HBC has been fined $1.9 billion for inappropriate banking systems ranging from money laundering and $1.4 billion in UK customer redress. In addition, there is some concern the basic size of HBC is not as efficient or adept at cost controls and oversight as smaller, less cumbersome institutions. However, this comment can be leveled at most large multi-national financial institutions. In addition, HBC has been implicated in the LIBOR scandal that has yet to be fully resolved.

HBC offers a quarterly dividend and a goal of a 50% payout ratio. Over the past 12 months, the company paid a total dividend of $2.25 per ADR (3 quarters of $0.45 and one of $0.90). It is not uncommon for HBC to pay a variable dividend in March based on the prior year's performance, and the March 2013 payment of $0.90 is an increase of 14% over the $0.70 paid in March 2012. HBC also announced an increase of its quarterly dividend from $0.45 to $0.50.

HBC's share price over the past 5-years has been in line with the overall performance of S&P Financial ETF (XLF). A 5-yr chart with HBC and XLF is below:

4th quarter and full year 2012 earnings conference call can be found here.

Earnings per share are expected to be in the $5.50 to $5.80 range per ADR for 2013, before extra charges if any. Share prices are trading at $55 with a reasonable price target of the low $60s based on a P/E ratio of around 11. Operating earnings have the potential to grow at a rate of 15% and earnings per share in the 12% to 15% range. With a dividend yield of around 4.3%, total stock returns could be in the 10% plus range.

Investors looking for international financial exposure should review HBC. HBC holds a dominant position in cross border trade with China as it is a preferred banking location for China transaction, and a stronghold for HBC. Holding HBC in a portfolio compliments US banks such as JP Morgan (JPM) and Wells Fargo (WFC) who do not have as much exposure to international growth markets.

Author's Note: Please review important disclaimer in author's profile.

Disclosure: I am long HBC. 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.