HSBC: A Short Story

| About: HSBC Holdings (HSBC)

Summary

The U.S. rate increase alone will not be reason enough to own the share.

Potential cost misses in 2017 as HSBC expanded its cost program by c.25%.

While capital repatriation from the U.S. will fund share buybacks and keep dividends in line, a new management team may reset the dividend and retain capital for potential growth ahead.

Introduction

As a bank, HSBC (NYSE: HSBC) has always been an interesting stock to analyze. Many, in the past, have argued that the stock is a good buy, especially after it gained 22.5% in 2016. However, I beg to differ. The bank faces a number of headwinds which the market doesn't seem to price in at the moment. The market currently has been willing to look through near-term earnings weakness, focusing on HSBC's U.S. dollar earnings, its exposure to rising U.S. interest rates and the potential for capital return. With the recent appointment of Mark Tucker as the new Chairman, shareholders are looking for a stronger growth story. I sincerely believe that the stock won't have a stellar performance as seen in 2016, based on the considerations addressed below, and that the stock makes for a good short over the next 8-12 months.

Missed 4Q16 Estimates - What's Going On?

HSBC's adj. 4Q16 PBT of $2.6B (all dollar values in USD unless otherwise noted) was 25% below company consensus and the miss was overwhelmingly driven by income, down 13% QoQ on HSBC's adj. basis. The bank left out $742M of its own debt swap losses in its adjusted figures and expects the swap losses to unwind over the life of the debt. A major aspect of the sequential decline in income is down to weaker sterling, Mexican peso and Egyptian pound FX rates versus the greenback. HSBC tends to focus on a constant FX-operating income approach which may lead to a more stable picture, but which does not account for a miss in costs. I would have adjusted for the debt swap losses to get a clearer picture. The trouble is that, even adjusting for the swaps hit and the items excluded by HSBC, divisional revenue trends look weak. No one division stands out and only GBM posts a positive YoY growth.

Banking on Rates Too Much

In my view, so far the market has been willing to look through near-term earnings weakness, focusing on HSBC's U.S. dollar earnings, its exposure to rising U.S. interest rates and the potential for capital return. However, I think that a potential U.S. rate hike will not have a major impact on income and the outlook remains subdued as there doesn't seem to be a correlation between HSBC margins and U.S. rates. Competitive dynamics in Asia will determine whether shareholders or depositors benefit from higher short-end interest rates.

Management has recently commented that a 10% ROE is the best that can be expected even with the recently improved interest rate environment. Apart from higher interest rates, what could change this - further cost cutting, balance sheet rationalization, consolidation and pricing power within the industry? A higher interest rate environment alone simply doesn't justify buying the stock.

Buyback Story Isn't Clear Enough

While analysts had previously anticipated $2B share buybacks a year between 2017 and 2019, funded by capital repatriation from the U.S., I was surprised to see a $1B share buyback for 1H17 funded by capital freed up by the disposal of the bulk of its business in Brazil in 2016. While management is clear that its primary aim is to redeploy surplus capital internally in order to deliver return accretive growth, opportunities to do this appear to be relatively limited in the near term.

The bank has also received regulatory approval to begin repatriating surplus capital from the U.S. and management has indicated that there is $8B surplus capital in the U.S. Since the North American region has been the main laggard, in terms of profitability relative to company targets, I don't see a clear picture on the degree of buybacks for U.S. growth ahead.

Conclusion: SELL

The macroeconomic story for HSBC pans out like this: HSBC's main markets are the U.K., U.S. and Hong Kong. With a potential slowdown in the Chinese market combined with growing concerns on capital outflows from China, and the possibility of a U.S.-China trade war, I estimate that the bank will face a slower Chinese economy in the year ahead. The U.S. business is currently lagging and no measures have yet been announced to push growth in the U.S. market currently. The U.K. is expected to face turmoil due to Brexit and the bank may have to focus on shifting jobs from London.

Fundamentally, HSBC hasn't shown any major improvement on a divisional level, apart from GBM posting positive growth. So where's the growth story? If it's through buyback and capital retention, management hasn't provided a clear picture to it and I see limited opportunities ahead which won't justify the current upbeat sentiment. Sure, HSBC will look to maintain dividend ahead which is good news for shareholders. I suspect that the new Chairman and his management team will reset dividend expectations ahead and make it the "new normal". With two Fed increases expected, bank stocks will be more attractive. But there doesn't seem to be a correlation between HSBC margins and U.S. rates. So what's driving growth ahead for shareholders in 2017, 2018 and beyond?

Based on the above thesis, HSBC makes for a good short over the next 8-12 months.

Disclaimer: I am not a licensed investment adviser. As I have no knowledge of individual investor circumstances, readers are expected to complete their own due diligence before purchasing any stocks mentioned or recommended.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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