The Analysis of Investing in HSBC
HSBC is one of the largest banking and financial services organizations in the world, with market capitalization of US$ 185 billion at 20 June 2008. In the past decades, it has given its investors satisfactory return. Will this legend continue, especially in the “once-in–a–century Credit Tsunami”? Let’s have a deep inside view from the following two perspectives.
From a positive perspective, risk always associates with opportunity. In the following, we talk about the advantages and potential opportunities HSBC have.
First of all, its reputation as one of the most reliable banks in the world and its prudential management characteristic are the great asset HSBC has. In the company’s history, China’s Qing Dynastic has ever been the largest borrowers, but the Chinese bourgeois democratic revolution led by Dr. Sun Yat-sen which overthrew the Qing Dynasty made that part of loan become bad debt; during WW II, Hong Kong was fell into Japanese army’s hand; In 1949, after People’s Republic of China was established, the government expropriated HSBC’s asset in Shanghai. Any one of the above disasters can destroy a mega-bank, but the outstanding and foresighted management led HSBC overcome all of the difficulties.
At this crisis, HSBC consistently shows its excellence in risk management by being the first one to disclose its subprime related asset, making loan impairments charges, and tightening its underwriting standard and reduce the size of loan portfolio in United States.
Secondly, HSBC recorded a much better than expected performance during the crisis. The drop of EPS, ROE, and the increase of loan impairments charges in the first half of 2008 compared with the same period in 2007 were unavoidable under such terrible environment. But we still found much surprise from the result.
| | 2006 | 1H2007 | 2H2007 | 2007 | 1H2008 | 1H07 -> 1H08 | 2H07 - > 1H08 |
| US$ million | % Growth |
| Loan to Customers | | 868,133 | 928,101 | 981,548 | 981,548 | 1,049,200 | 13.05% | 6.89% |
| Total Asset | | 1,860,758 | 2,150,441 | 2,354,466 | 2,354,466 | 2,546,678 | 18.43% | 8.16% |
| Customers' Deposit | | 896,834 | 980,832 | 1,096,140 | 1,096,140 | 1,161,923 | 18.46% | 6.00% |
| Net interest spread | | 2.94% | 2.93% | 2.80% | 2.86% | 3.03% | | |
| Net interest income | | 34,486 | 18,230 | 19,565 | 37,795 | 21,178 | 16.17% | 8.24% |
| Cost efficiency ratio |
| 51.3% | 48.3% | 50.4% | 49.4% | 51% |
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From the table above, its customers’ deposit rose 18.46% in the first half of 2008 compared with the same period in 2007. I believe that, as one of the most trustful banks, HSBC successfully attracted much low cost deposit from the customers who are seeking for safe shelter for their capital. At the same time, the decrease of benchmark rates all around the earth such as LIBOR and Fed fund rate affect the deposit interest rate but not the loan interest rate due to the demand for money continue rising during the credit crisis. As a result, its interest spread reached the highest in first quarter 2008.
Besides, the satisfactory result was not merely from its growth of deposit, but also from the growth of total asset and customers’ loan, as well as the excellent cost control. As a bank, the continuous growth in profit cannot sustain without the growth in total asset. The total asset and customers’ loan rose 18% and 13% respectively in the first half of 2008 compared with the same period of 2007. This result was achieved in the background of tightening its business in US market. It was mainly due to its good performance in Europe and emerging market and many companies return to bank asking for financing in the case of deterioration of security market.
Further more, the cost efficiency ratio was well controlled even though the sharply increase in loan impairments charges.
The third, HSBC had an excellent risk management.
HSBC Finance Corp.
P29, HSBC Holdings Plc Interim Results 2008
| | 30 Jun,2008 | 31 Dec, 2007 | 30 Jun, 2007 |
| Core tier 1 ratio | Basel II | 7.70% | 7.80% | |
| | Basel I | | 8.40% | 8.40% |
| Tier 1 Ratio | Basel II | 8.80% | 8.70% | |
| | Basel I | | 9.30% | 9.30% |
| Loan impairments charges | US$ Million | 10,058 | 10,896 | 6,346 |
From the figures above, although the amount of loan delinquency continued rising, it rose at a much lower pace in the first half of 2008. Besides, the increase of the delinquency amount as a percentage of total loans was largely due to the contraction of the size of customers’ loans. Further more, the loan impairments charges started to decrease in the first half of 2008, compared with the second half of 2007. It has been more than 18 months since HSBC was aware of the risk of the subprime asset in 2006 and tightened its underwriting standard, I believe the most risky loan has been exposed, the loan impairment charge may continue as the economics become worse, but the possibility of sharply increase of loan impairment charge per period is much lower than before.
HSBC also was one of few banks which can increase its tier 1 capital without any type of financing or cash injection. Recently, HSBC rejected the rescue plan from British government, and at the same time lend out 20 billions pound to other financial institutions. HSBC has always been the net lender in the interbank market for long time, and it even lent out more during the crisis. The net lend amount rose around 20% in first half of 2008 compared with the same period of 2007. All of them are power evidence telling the HSBC has sufficient cash to pass through this crisis. One more advantage from the adequate capital is that HSBC doesn’t need to sell its debt investment at current extremely low market price and continue receiving coupon and interest till the maturity. As a result, large part of the impairment charges for its financial investment will be reversed. As we know that, impairment charge is merely an accounting treatment, but if it sells it at this moment, the loss between the purchase price and the current market price is the real cash outflow. Merrill Lynch previously sold its CDO asset for 6.7 Billions which is initially worth 30 Billions. I am sure such kind of suffering will not happen to HSBC.
The fourth, in the crisis, HSBC can have opportunities to acquire undervalue assets. Nowadays, only a few financial institutions can obtain capital through issuing new shares, HSBC is absolutely one of them. Issuing new share can also increase the net asset value per share of a bank which is good for investors. Looking back at the history, HSBC successfully used this strategy to expand its business and become the “world’s local bank”. Recently, Bank of America has acquired Merrill Lynch; Wells Fargo eventually defeated Citigroup and bought Wachovia. I believe that HSBC won’t waste this chance and is actively seeking for its target now.
Finally, as long term investors, we cannot neglect the consideration of company’s dividend policy. In the first half of 2008, the dividend rose 6% associated with 32% dropped in EPS. In the past 30 years, the situation that EPS dropped compared with the previous year totally appeared 4 times, but the dividend payout kept rising in each time. During the time, the compound growth rate of dividend is 16.9% per annum. No one would deny the priority of shareholders’ benefit in the mind of HSBC’s management.
Undoubtedly, HSBC is one of the most successfully banks in the world, and there may be numerous opportunities waiting for it. But from the other perspective, we cannot underestimate the difficulties it is facing and the factors which have negative impact on its profit.
At first, nowadays, the crisis has spread out from sub prime market to prime market, from financial sector to all other sectors such as manufacturing and retail, from United States to Europe, and all around the earth. Unemployment rate is rising, recession is foreseeable. Will it be worse and become a great depression? No one knows. But it is clear that there is long way to go. Everyone knows the US real estate market is the origin of this recession. Based one the data in Aug, 2008, it need to spend more than 11 months to sell the current house in stock. How the prices of house move? If you need to take around 1 year to sell your entire inventory, will you cut your price to sell them? Absolutely! Without the support of housing price, the start of new prosperity is merely a dream.
During the crisis, although we are confident that the possibility of bankruptcy of HSBC is very low, the major concern is whether its loan quality will deteriorate further, there will be significant amount of loan impairments charges coming and negative affect the profit. Secondly, from the table below, HSBC’s non interest income is apparently dropping. The third, when HSBC need to issue new debt or refinance its current debt, the cost will rise dramatically.
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| 1H2007 | 2H2007 | 2007 | 1H2008 |
| Net fee income | 10,495 | 11,507 | 22,002 | 10,991 |
| Net trading income | 5,511 | 4,323 | 9,834 | 3,834 |
Besides, in order to save the financial institutions and improve people’s confidence, most of the major countries in the world provide unlimited insurance for depositors. Under the coverage, some people are willing to deposit its money into small banks to earn higher interest rate. HSBC may lose its advantage as one of the safest banks, and the interest for customers’ deposit may rise.
Currency conversion issue is another factor we need to pay attention. The appreciation of Euro and Pound positively contribute to the profit of HSBC since large portion of its business is in Europe. The total effect of foreign currency translation rate accounted for increase of 4% in profit before tax of first half of 2008 compared with the first half of 2007. In the last several months, Euro recorded a big depreciation compared with Dollar and it will negatively affect the profit in 2008.
Finally, let’s talk about some other negative factors. From the interim report, it records 824 million of “Gain on debt designated at fair value and related derivatives” in the first half of 2008 under US GAAP SFAS 159 (2883 million on the second half of 2007). It would become the real profit only if the debtor has the power to repurchase the debt in market price. It won’t have any benefit generated if the debt keeps going till the maturity. It depends on the power, not willingness. So it had better be excluded from income. 2008 is also the year of natural disaster for United States such as floods and tornados. Loan impairments charges and insurance claims may rise in the third quarter. In 2005, HSBC recorded 180 millions loan impairment charges for Katrina.
Based on my analysis, I use a three stages dividend discount model to calculate the reasonable stock price of HSBC. Conservatively, I assume the dividends won’t increase in 2008 and 2009; the dividend will increase 10% annually from 2010 to 2014; the dividend growth rate will keep in 6% thereafter. Finally, I use 11% as discount rate and 30% margin of safety. So the reasonable price based on that is 19.24 US dollar (equivalent of 149 HK dollars).
From the perspectives above, the future of HSBC is full of opportunities and currently its stock is undervalued. I should mention that, before making investment decision, we must consider how long our holding period of this investment will be, how much return we expected and risk we can afford!
Historical Earning and Dividend Data (adjusted) of HSBC
| Year | Net Income | Earning Per Share | Dividend Per Share | Year | Net Income | Earning Per Share | Dividend Per Share |
| HK$ Million | HK$ | HK$ | HK$ Million | HK$ | HK$ |
| 1978 | 829 | 0.1930 | 0.0928 | 1993 | 20,624 | 2.7300 | 0.9400 |
| 1979 | 1,111 | 0.2790 | 0.1288 | 1994 | 24,334 | 3.1400 | 1.1000 |
| 1980 | 1,531 | 0.3870 | 0.1810 | 1995 | 30,044 | 3.8200 | 1.2800 |
| 1981 | 2,116 | 0.5080 | 0.2337 | 1996 | 37,587 | 5.1500 | 1.7930 |
| 1982 | 2,357 | 0.5450 | 0.2636 | 1997 | 42,550 | 5.3600 | 2.1330 |
| 1983 | 2,492 | 0.5690 | 0.2900 | 1998 | 33,447 | 4.1900 | 2.4030 |
| 1984 | 2,591 | 0.5930 | 0.3032 | 1999 | 41,961 | 5.0700 | 2.6520 |
| 1985 | 2,719 | 0.6290 | 0.3335 | 2000 | 51,645 | 5.9200 | 3.3900 |
| 1986 | 3,056 | 0.7030 | 0.3567 | 2001 | 42,167 | 4.5700 | 3.4300 |
| 1987 | 3,593 | 0.7860 | 0.3806 | 2002 | 48,658 | 5.2300 | 4.1300 |
| 1988 | 4,300 | 0.9080 | 0.4410 | 2003 | 68,325 | 6.5400 | 4.6800 |
| 1989 | 4,774 | 1.0000 | 0.5090 | 2004 | 92,222 | 8.4900 | 5.1500 |
| 1990 | 3,096 | 0.6400 | 0.5200 | 2005 | 117,300 | 10.5800 | 5.6900 |
| 1991 | 5,664 | 1.1600 | 0.6166 | 2006 | 123,154 | 10.9200 | 6.3100 |
| 1992 | 14,321 | 2.4300 | 0.7600 | 2007 | 144,068 | 12.7700 | 6.7300 |
