HSBC: Beyond The Crisis

by The U.K. Income Investor

Asian banking giant HSBC (HSBA) has had a tough decade. Truth be told, that was true even before COVID-19 created what looks like an economic meltdown. Its share price had gone sideways at best, making the dividend the only major source of shareholder returns. Depending on when exactly you measure from, real returns could easily be negative. For that reason, it wouldn’t surprise me if investors gave this one a wide berth; doubly so given that many people would characterise banks as fairly risky beasts after what happened just over a decade ago.

Two things have gone wrong here in my view. Firstly, non-existent profit growth. Granted, it hasn’t been the easiest environment for banks in recent times, but still. Its target of earning a double-digit return on equity always seems to be just around the corner. The bank was making circa $12B in annual net profit attributable to ordinary shareholders pre-COVID-19; that’s slightly less than what it made five years ago.

The more important issue has been its valuation. There’s nothing inherently wrong with no growth, but then ideally you would want a double-digit earnings yield to compensate. HSBC stock has not often offered that. Moreover, the bank pays out most of its profit by way of dividends to stockholders. If it regularly yields 5% to 6%, well, that’s about all you can expect by way of total returns. On that basis, I’m not sure it has been that much of a deal in recent years.

COVID-19

On that note, we arrive at the current crisis. Like most banks, HSBC has been hit quite hard; its shares are down around 30% since the turn of the year. The bank’s first quarter results, released earlier this week, give us a taste of what may come. Adjusted profit before tax came in at $3B, down around 50% on 1Q19. The $3B or so that the company set aside for bad debt, the highest in nearly a decade, explains the severity of the drop.

Of course, 2020 looks like it will be a horror show for most corporations, never mind the banks. The company warned that its total loan loss provision could hit $11B this year, though the situation remains volatile. Furthermore, lower interest rates rates will eat into its net interest income (the difference on what it earns from interest bearing assets like mortgages, versus what it pays on liabilities like customer deposits). HSBC reckons that headwind will amount to over $3B this year compared to last year.

With that as a backdrop, it’s not all that surprising that the bank chopped its dividend for the year. That angered some of HSBC’s investors in Hong Kong (where the bank also has a stock market listing and makes most of its profit), but I’m not sure it’s such a big deal. In a worst case scenario it preserves what may turn out to be some much needed capital. If things don’t turn out so bad, well, then it simply ends up as excess capital that can be released later on via dividends or stock buybacks.

Beyond The Crisis

Speaking of capital, HSBC is in much better shape than it was in the global financial crisis. The company had around $2T in interest-earning assets outstanding at the end of the quarter. Some – such as the $40B or so in loans for mining and oil extraction – probably don’t look so great right now. Others – government debt for instance – will be just fine. On that basis, its risk weighted assets stood at just under $860B at the of 1Q20.

As the name suggests, that figure takes into account the nature of the bank’s assets. A billion dollars lent to the United States government is a different beast to a billion dollars lent to a US shale oil company, though both would be assets for the bank. Anyway, common equity tier 1 capital (CET1) stood at $125B last quarter, which gives the bank a current CET1 ratio of 14.6%. Suffice to say, it is in much more conservative shape than in the years leading up to the crash. We can expect its risk weighted assets to rise as credit quality deteriorates during the downturn. This will eat into its capital buffer, but I expect it should be fine overall.

As an inherently low growth bank struggling to earn decent returns on its assets, I’d be inclined to demand a high single-digit dividend yield here in normal times. The bank pays out most of its profits that way, so it stands to reason that shareholder returns won’t get much better than the reinvested distribution. If it eventually resumes per-share profit growth, then great. If not, well, we get decent shareholder returns anyway. On that basis, HSBC stock is probably reasonable value right now. Granted, dividends look off the table for the next few quarters, but eventually things will settle down. If it can return to earning north of $12B in net profit, then investors face a high single-digit forward dividend yield once payments resume. That strikes me as an okay deal, even if it does take a couple of years to play out.

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