HSBC - A Stumble, Not A Fall

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About: HSBC Holdings plc (HSBC)
by: Regents Research
Summary

HSBC has hit a fallow patch lately with the shares doing no better than other European banks and lagging UK peers like Lloyds year-to-date.

Optimism has waned as the company has struggled to grow revenues faster than costs and as payouts have appeared to stagnate.

However, I view this as a blip rather than a fundamental change to what remains for me one of the most positive investment thesis amongst European financials.

The core proposition of HSBCis the same as before: it is a business that has been progressively re-focused to areas where it can generate both growth and good returns. This will support higher earnings and payouts over time, all with a lower risk profile than other banks due to the company's strong geographic diversification.

The HSBC story has derailed lately

HSBC's (NYSE:HSBC) star has waned recently and following a period of strong performance in 2017/2018 (15% outperformance vs. the European banks index and 5-20% outperformance vs. UK peers) the share has slipped back this year. Year-to-date HSBC is essentially flat and no better than the European sector average while it has underperformed Lloyds (NYSE: LYG) by 10%.

Source: FT markets data

A number of factors have combined to dent enthusiasm for HSBC. Notably, an acceleration in cost inflation driven by investments ($4.1bn in FY18) saw the company miss its target of delivering positive "jaws" last year for the first time since 2015 (faster revenue growth than cost growth).

In addition, a softer interest rate environment, especially in Hong Kong, has seen interest margins reverse (1Q19 NIM was the lowest since 2017), which has adversely impacted revenue growth even as lending volumes continue to grow robustly.

Finally, and perhaps most importantly, payouts to shareholders have not accelerated at the pace that had been hoped for. The dividend was held flat in 2018 and management has yet to commit to the share buy back for 2019, saying in the 1Q results that a decision won't be made until mid-year.

But the fundamental investment thesis remains intact

With HSBC already trading on a premium valuation rating to peers (it is one of the few banks in Europe rated at a premium to net asset value on 1.1x) it is not that surprising that these setbacks have seen the share slip.

However, it would be a mistake to lose sight of the bigger long term drivers of the HSBC investment thesis, all of which remain intact and which I recap on below.

The top line is growing

One of the main reasons I like HSBC is because earnings momentum is accelerating (EPS is expected to grow by 14% in 2019) and it should remain positive relative to many other banks, especially in Europe. Unlike peers, HSBC is not trying to shrink its way to glory by continually cutting costs. Instead, earnings growth is coming predominantly from higher revenues as the company capitalizes on its exposure to faster growth economies in Asia.

The company went through a major balance sheet redeployment exercise in 2015 but this is now largely complete and lending volumes are rising. The following charts show that, having troughed in 2016 total revenues have since grown by 20% (1Q19 annualized vs. FY16).

Source: company report & accounts

Over the same period, lending volumes are up 17%. What is especially impressive is that this lending growth is very "efficient" from a regulatory capital perspective since risk weighted assets (RWA) over the same period have grown by only 1% (RWA is the denominator for calculating HSBC's regulatory capital ratio) .

Source: company report & accounts

This is the result of the de-risking HSBC has undertaken in recent years, including:

  • The redeployment of $290bn of higher-weighted but lower yielding RWA from 2014 onwards (25% of the group total)
  • The run-off of the higher risk US subprime mortgage book where remaining balances are now de minimus
  • The exit from certain higher risk emerging markets activities, notably the disposal of HSBC Bank Brazil in 2016, which not only reduced RWA by $40bn but also enabled the $2.5bn share buy back that was executed that year.

While the market has tended to focus only on the downward trajectory of HSBC's net interest margin it is important to remember that this reflects not just the pressures of low interest rates but a structural change in the nature of HSBC's lending activities towards lower risk areas.

Source: company report & accounts

The important point in all of this is that HSBC does not any longer have a revenue growth problem. The top line has been growing robustly for over 2 years since the inflexion point in 2016. This sets the bank apart from many others and makes it much easier for management to deliver its return targets, providing, of course, that costs can be kept under control.

Positive jaws has already been reestablished

The first thing to say on costs is that 1Q19 is already pointing to a much better outcome than FY18, where the company mainly missed its positive jaws target because market-related revenues in 4Q came in much weaker than expected.

1Q saw revenues rebound, posting 9% year-on-year growth whereas costs were only 3% higher, giving a 6% positive jaws for the quarter.

This pace of improvement almost certainly cannot be maintained for the rest of the year. But there other solid grounds for thinking that the cost disappointment of 2018 won't be repeated.

One important factor to bear in mind is that management does have a relatively large element of control over the cost number since a sizable chunk comes from discretionary investment spend. The budget for investments is $5bn for 2019, which would be close to 20% of the underlying cost base. Management have clearly indicated that there is scope to flex this number should revenues take a turn for the worse in coming quarters.

We'll remain committed to investing sensibly and sustainably. And as we guided to at our strategy update last year, we expect to increase investment this year to around $5 billion with $1 billion spent in Q1. We will, however, continue to proactively manage investment in line with the more uncertain outlook. (CFO Ewen Stevenson, 1Q19 earnings call)

Source: company report & accounts

Given the profile that the issue of costs has attained among investors after last year's miss I expect there will be much more careful management of investment spend this year to ensure the positive jaws target is delivered for 2019.

This is especially the case since the positive jaws target is embedded within the performance appraisal of senior management. It makes up 10% of the CEO's annual appraisal and 15% of the CFO's annual appraisal, giving HSBC's management a particular incentive to deliver.

ROTE is on an upward track

Higher profits combined with a largely stable equity base should translate to higher return on tangible equity. And on this key metric HSBC is already above the level of most of its peers and indeed it is increasing the gap.

Underlying ROTE in 2018 was already 10.2% and it increased to 10.6% in 1Q19, not far off management's target of >11%. Among European banking peers there is only a handful of others delivering double-digit returns.

Source: company report & accounts

HSBC is much more exposed than other banks to growth regions

Superior growth and superior returns are the consequence of HSBC's attractive geographic mix and this is one of the key attractions of the stock, in my view.

Hong Kong and the broader Asia region account for 50% of group revenues and HSBC has identified several future growth drivers, including:

  • The Pearl River Delta (PRD) area of China, which has natural synergies with the group's existing presence in Hong Kong. The PRD is viewed by HSBC as an area creating a revenue pool that could eventually be as large as Hong Kong.
  • ASEAN, which has naturally high rates of growth and where HSBC enjoys special competitive advantages due to its extensive network
  • The Chinese Belt and Road initiative, where HSBC is well positioned to benefit from lending and other revenue opportunities.

Source: company report & accounts

HSBC's core Asian markets seem likely to continue to deliver above-average levels of income growth based on current GDP forecasts. The IMF anticipates that China and the ASEAN-5 region will continue to grow at almost 3x the pace of the US, Eurozone and UK out to 2024.

Source: IMF

HSBC's interest rate sensitivity mainly lies outside the Eurozone

A final potentially important part of the HSBC investment thesis is the company's interest rate gearing. Softer rates, notably in Hong Kong, have recently been a headwind not a tailwind. But if global rates do move higher again then HSBC stands to be one of the big beneficiaries among global banks in view of its strong deposit franchise and liquidity position.

The company's disclosures show that a 100bps increase in global interest rates would add ~14% to group net profits. Importantly, HSBC's rate sensitivities are mainly to Hong Kong, the UK and other emerging markets where the plausibility of higher future interest rates seems greater than in the Eurozone, for example.

Source: company report & accounts

HSBC should be able to sustain higher payouts

Disappointment on recent payouts has been a key factor in HSBC's recent weak share performance as management has adopted a cautious stance in light of short-term uncertainties such as Brexit. The 2018 dividend was held flat and management has yet to commit to the size (if any) of the 2019 buyback program.

However, several factors suggest the scope for future, potentially sizable increases in payouts will be large.

  • As earnings continue to grow the dividend payout ratio is falling. Having been 106% in 2017 the payout ratio in 2019 is estimated to be down to 72%. Importantly, the risk of future disruptive, outsized litigation expenditures is also declining.

Source: company report & accounts, Reuters consensus data

  • HSBC's regulatory core equity tier 1 ratio is already above management's 14% target and is among the highest of European peers at 14.3% in 1Q19. This is an impressive turnaround with the ratio having been just 10.9% as recently as 2014 when the prospect of dividend cuts was very real.

Source: company report & accounts

  • Lending growth is coming mainly in capital-efficient segments like mortgages. I noted this point already and it is important when thinking about the trajectory of the core equity ratio since it means payouts and balance sheet growth are not mutually exclusive. HSBC should be in a position to return the bulk of annual profits to shareholders whilst still maintaining its regulatory capital ratio at an acceptable level.

Clarity on the level of this year's buyback will be an important catalyst for the share when it comes with the 2Q results. But even without the buyback HSBC is delivering a 6.4% yield with scope to grow payouts in line with earnings.

Conclusions

HSBC's recent share price weakness looks more like a stumble than a fall and the key components of the investment thesis remain intact. These are: positive revenue and earnings momentum, rising ROTE, strengthening organic capital generation and the risk diversification afforded by HSBC's diverse geographic footprint.

While the shares trade at a premium to peers (11x PE, 1.1x P/TNAV) I regard this as a warranted premium given the company's superior growth prospects and lower risk profile.

Earnings growth is forecast to be among the highest in the industry over the next couple of years (14% CAGR) and as we get clarity on the level of this year's payout I expect the shares to get a fresh lease of life.

A return to the stock's historic average P/TNAV multiple of 1.3-1.4x would imply upside of ~30% is possible with lower downside risks than other banks. On that basis, HSBC for me remains a core holding.

Disclosure: I am/we are long HSBC. 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.