HSBC Has A Valuable Core Franchise, But A Lot Of Work To Do

| About: HSBC Holdings (HSBC)
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Summary

Impairments have shrunk considerably, but HSBC is still facing elevated bad debts, very weak spreads, and a need for even more regulatory capital.

HSBC's Hong Kong franchise is a star, and the U.S. and U.K. businesses hold low-cost deposits that will help boost returns when the rate curve steepens again.

HSBC doesn't look tremendously cheap on a long-term ROE estimate of 12%, but the underlying potential may be greater than that and offer worthwhile upside as a credit repair story.

The giant global franchises of Standard Chartered (OTCPK:SCBFF), Citigroup (NYSE:C), Deutsche Bank (NYSE:DB), and HSBC (NYSE:HSBC) definitely didn't live up to the notion that a global footprint would insulate them in tougher times. In the particular case of HSBC, it got to a point where some started asking whether it was actually a good global bank or just a very good Hong Kong bank with a lot of foreign market albatrosses dragging it down.

The truth, as is often the case, is somewhere between. HSBC certainly made some big mistakes in markets like the U.S., and the China operation has its challenges today, but Hong Kong continues to be exceptionally profitable and the large low-cost deposit bases in the U.K. and U.S. give the company attractive leverage to rising rates.

Here, There, And Nearly Everywhere

HSBC operates over 6,000 offices in 80 countries, but the business is not nearly as balanced as that might sound. Over half of the company's offices are in the U.K., as well as more than a third of the company's loan book. Hong Kong accounts for 18% of the loan book and 12% of the risk-weighted assets, but produces about one-third of its profits. While the company largely exited its retail operations in the U.S., this country still accounts for about 11% of the loan book. So, while HSBC is indeed quite diverse in many respects, two-thirds of the loan book is attributable to three countries.

In the decade leading up to the credit crisis, I believe management at the time made a lot of "growth for growth's sake" decisions. Many of these businesses proved to be sub-scale and/or generated unattractive returns and the company has since been on a real diet - shedding over 60 businesses including the U.S. credit cards and retail branch businesses.

Not all of the problems are in the past, though. The company's stake in China's Bank of Communications has seen its fair value fall 40% below its carrying value, as its weak retail franchise continues to struggle. HSBC is also still seeing high levels of bad debt - its 3.3% non-performing loan ratio is well ahead of those of Citi and Standard Chartered, and it gets worse when you realize that the NPL ratio in Hong Kong is 0.2%, 2.6% in Europe, and over 9% in North America and Latin America.

Even with these issues, HSBC is not giving up on its global operating strategy. Management has identified 20 priority growth markets, including Mexico (over 1,000 offices), Brazil (over 800), China (nearly 200 offices), India, Singapore, and Turkey. Beyond these growth-oriented opportunities, HSBC also has some overlooked quality operations, like its business in Canada that generates a very nice mid-teens ROE on a capital base of around $80 billion.

Capital Needs Still An Unknown

In the wake of the credit crisis regulation has come back into vogue, with many governments taking a much firmer line with banks and their capital needs. Regulators are particularly wary of banks with complex international operations and that is clearly an issue for HSBC. When the U.S. Fed rejected the company's CCAR plan, they cited "significant deficiencies" in the capital planning process and oversight.

HSBC is pretty well-capitalized by conventional reporting standards, with a Basel III CET1 ratio of 10.8% for the first quarter. The problem is that the bank still has not gotten the final word from regulators (particularly in the U.K.) as to what its ongoing minimum capital requirement will be, though it looks as though it could be as high as 12.5%. HSBC won't likely have any particular problems getting to that level, but that enforced conservatism is going to put a damper on the company's future ROE and may well make management's prior goal of 12% to 15% long-term ROE too much to hope for.

Credit Repair Coming, But When Will Spreads Rebound?

I mentioned the company's ongoing high NPL level previously, but it wouldn't be fair to say that HSBC's credit situation has not improved. Impairments have fallen from $26.5 billion in 2009 to $5.8 billion in 2013 and were better than expected in the first quarter of this year. In my view, barring another calamitous global recession, HSBC is pretty nearly out of the woods with respect to credit.

Bad debts most definitely hammered HSBC's profitability, but it has not been the only challenge. The global drop in interest rates has led to significant spread compression and that shows up in HSBC's net interest margin - NIM has fallen from about 3.2% in the first half of 2005 to 2.1% in the second half of 2014. That may not sound like a big deal, but when you multiple it by the significant leverage that HSBC employs, it adds up.

The good news for HSBC is that it has a large base of low-cost deposits in the U.S. and U.K.. As the rate curve re-steepens, this low-cost funding base should help the company fix its below-average net interest margin and post better ROEs. The issue is when this will happen - many analysts thought we'd already be seeing rates heading higher by now.

12% ROE Doesn't Look Like Enough

HSBC management still has a lot of work to do. The business in Hong Kong is exceptional, but take that business out and HSBC is a single-digit ROE-generator. Investing for long-term growth does make sense in many markets, but running a global banking franchise is expensive and HSBC needs to improve its overall operating cost base.

Reconciling positive contributions from a better rate environment, improved cost control, and credit repair with higher capital demands and competition, I believe that management can get to a 12% steady-state ROE. An ROE in the mid-teens looks possible, but I'd argue that that is a bull-case scenario that management must prove it deserves. A 12% ROE in 2018 would imply double-digit annual earnings growth over the next five years (on average), but it only discounts back to a fair value of around $52.50.

HSBC's underlying return on tangible equity paints a brighter picture, as the resulting "fair" multiple to tangible book value works out a target of around $59. I would argue that the difference between the two reflects, at least in part, the difference between the potential of the business ($59) and the still-significant near-term challenges for management to address ($52.50).

The Bottom Line

Fix-er-up bank situations can offer significant outperformance potential and HSBC has yet to really see that trade. There are still a lot of headwinds - uncertainty about the company's capital requirements, the need to write down BoCom, worries about ongoing credit losses, ongoing flat rates, and so on. There's also the risk that a large multinational banking franchise just doesn't make sense in the new banking world.

I can't say that HSBC looks so cheap today that it's a must-own or even a must-consider. I will say that credit repair stories can get better faster than the numbers would suggest and leave those valuation models in the dust. As a somewhat speculative recovery story, then, I do think HSBC has some appeal for more risk-tolerant investors.

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