HSBC: Is The Dividend Sustainable?

| About: HSBC Holdings (HSBC)
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Summary

HSBC is a global bank with a large exposure to Asia, giving it good growth prospects in the long term.

It is also one the European banks with more leverage to higher U.S. interest rates.

HSBC's strong capital position supports its dividend yield above 6%, which seems sustainable even though it is not among the safest in Europe.

HSBC Holdings (NYSE:HSBC) is a global bank with a sizeable exposure to Asia, giving it a unique profile among the largest banks in the world. Its recent financial performance has been relatively weak, but should normalize in the next few years, and HSBC is one of the European banks most geared to higher U.S. interest rates. Its capitalization has improved markedly, supporting its high dividend yield of 6.4%.

Company Overview

HSBC is one of the world's largest banks, with a history dating back to 1865. Its roots are based in Hong Kong, but after the acquisition of Midland Bank in 1992, its headquarters were transferred to the U.K. HSBC has a market capitalization of about $160 billion and trades in the U.S. on the New York Stock Exchange.

The bank has a long tradition of supporting the local and foreign trade, trade finance being one of its most important businesses. Geographically, HSBC is a global bank with a sizeable exposure to Asia. Reflecting this profile, its closest peers are other global banks like Citigroup (NYSE:C), JPMorgan (NYSE:JPM) and Standard Chartered (OTCPK:SCBFF). Due to its large size, HSBC is a Global Systemically Important Bank (GSIB) requiring an extra capital buffer of 2%.

Since the global financial crisis of 2008-09, HSBC has performed a restructuring of its business, reducing its presence in several markets through a program of closures and disposals. The bank reduced its footprint to simplify its organization and be more focused in areas where it has higher profitability. It also considered a change of domicile away from the U.K., but decided to maintain its headquarters in the country in the next few years.

HSBC is very well diversified geographically and by business. Its main operations include retail banking, commercial banking, global banking and markets and wealth management. Retail banking generates about 40% of total revenues, global banking has a weight of 29% and commercial banking generates 27%. Geography, its largest market in terms of revenue is Asia (37% of total revenues), followed by Europe (33%), North America (14%), South America (13%) and the Middle East (4%).

One of HSBC's most distinctive factors is its significant presence in Asia, which has better growth prospects in the long term than the developed markets. The bank's loan book in Asia accounts for about 40% of the group total, and despite fears of China's slowdown, it has shown good credit quality in recent years and is still reporting higher loan growth than other geographies within the group.

Additionally, a focus on trade financing and multinational costumers supports its good credit quality, and unless China enters into hard landing, as some have expected over the past years, HSBC should continue to report a robust performance in Asia in the coming years.

Financial Overview

Regarding its financial performance, the bank has delivered mixed results since the global financial crisis. The low interest rate environment globally and China's economic slowdown had a negative effect on its growth and profitability. Additionally, HSBC also was affected by one-off effects, such as litigation and restructuring costs over the past few years, affecting its bottom line considerably.

More recently, HSBC has reported relatively weak results impacted by weaker markets, especially in emerging markets. Additionally, in 2016, the bank has made some adjustments to its accounts, like the write-down of goodwill in the European private banking business, making its underlying performance different from the reported figures. Excluding one-off items, its underlying performance was relatively stable from the previous year.

HSBC's revenues amounted to $50.1 billion in 2016, a decrease of 2% from the previous year adjusted for the divestment of the Brazil business. Its net interest margin (NIM) continued to decrease, down to 1.73% in 2016. This represents a decline of 15 basis points (bps) during the year and is the lowest level reported in the past few years. HSBC is highly exposed to U.S. interest rates, and recent Fed increases should lead to higher NIM in the next few quarters, probably making 2016 the bottom year as far as NIM is concerned.

Beyond constrained revenue growth, another factor that has been negative for HSBC's earnings is higher costs related to increasing regulatory complexity. The bank has hired staff to comply with more demanding compliance and regulation around the world, putting upward pressure on its cost base. To offset this effect, it has a cost reduction program ongoing to improve efficiency, having reached about $3.7 billion of annualized savings in 2016.

However, to achieve these savings, the bank has incurred more than $4 billion in costs to date; thus, the net cost reductions should only start to impact its net income positively in the coming quarters. Regarding credit quality, HSBC reported stable provisions in 2016 at a very low level of 31 bps of total loans, reflecting better economic conditions across its businesses.

In the past year, HSBC's profit was considerably impacted by one-off items, including goodwill write-off, restructuring costs and fair value adjustments of its own debt. These items contributed negatively to its profits by more than $12 billion. Without one-off items, what the bank calls its adjusted profits, HSBC's profit before tax would be only 1% lower than in 2015. Nevertheless, its reported profit for the year was very low, and earnings per share amounted to only $0.07, a drop of 90% from the previous year.

Given this poor reported profit, HSBC's return on equity (ROE) collapsed in the last year to less than 1%. However, adjusted for one-off items, its ROE was 7.2%, practically unchanged from the figure reported in 2015. HSBC's goal is to achieve an ROE above 10% in the medium term - a challenging target considering the bank's recent performance.

On the other hand, it is one of the European banks with higher leverage to higher U.S. interest rates. According to the bank, an increase of 25 bps in rates would increase its net interest income for 2017 by $1.7 billion, of which the vast majority of the benefit would come from U.S. rate sensitivity. Therefore, if the Federal Reserve continues to raise rates as expected in the next quarters, HSBC should report higher earnings and may report an ROE closer to its target.

Capital and Dividends

Regarding its capital position, HSBC has improved markedly its position during 2016 through the disposal of its Brazilian unit, organic capital generation and reduction of risk-weighted assets (RWAs). The bank reduced RWAs by $143 billion in 2016, boosting its fully loaded core equity tier 1 (FL CET1) ratio.

This ratio is usually used to access the balance sheet strength of retail banks, and HSBC now has a very comfortable position. Its FL CET1 ratio was 13.6% at the end of 2016, a huge improvement from the 11.9% level reported in 2015. This capital ratio is even above its own target of 12-13%. Thus, HSBC is currently well capitalized and doesn't need to build much capital going forward. Additionally, its leverage ratio was 5.4%, which is very good compared to most of its peers, showing that the bank is properly capitalized.

This solid capitalization is clearly a strong support for its shareholder remuneration policy. HSBC's improved capitalization enabled the company to maintain its dividend unchanged in 2016 at $0.51 per share, while some investors expected a dividend cut. At its current share price, it has a dividend yield of about 6.4%. Contrary to most European companies, HSBC's dividend payment frequency is quarterly, being more attractive for U.S. investors.

Additionally, following the sale of its Brazilian unit, HSBC announced a share buyback of $2.5 billion, which was completed during 2016. Given its strong capitalization, the bank recently announced a further $1 billion share buyback to retire more of the capital that previously supported the Brazil business. This buyback should be completed during the first half of 2017, and further buybacks will be based on the overall view of the bank's capital position.

Despite its good capitalization and capital return policy, HSBC has one of the highest dividend yields among European banks, showing that investors are still skeptical about its capacity to maintain the dividend policy. In 2016, its total dividend payments amounted to $10.1 billion, a large amount even for a bank the size of HSBC.

Given that its reported earnings in the past year were abnormally low, HSBC's dividend sustainability metrics are quite poor. Its dividend per share of $0.51 wasn't covered by the reported EPS of $0.07, but this was an awkward year with a lot of one-off items that don't reflect the future earnings power of the bank.

Indeed, according to analysts' estimates, HSBC should report a net income between $10 billion and $14 billion in the next three years and EPS in the range of $0.52-0.70. This means that the dividend per share of $0.51 is expected to be covered by its earnings - a good signal for its long-term sustainability. The bank's dividend payout ratio should be high at about 80% of its earnings - a level that is acceptable taking into account its good capitalization, but doesn't give much room for error. Therefore, HSBC's dividend seems to be sustainable unless economic conditions deteriorate rapidly across the bank's geographies.

Conclusion

HSBC is a large bank with a strong presence in Asia, a profile that should give it good growth prospects in the long-term. Its recent financial performance has not been particularly impressive, but should normalize in the next few years and is positively impacted by expected higher U.S. interest rates.

The bank's capitalization has improved markedly following the sale of its Brazil business, being one of its most positive factors now. This strong capital position supports its attractive dividend yield above 6%, which seems to be sustainable, even though it is not the safest among European banks.

Disclosure: I am/we are long C.

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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