HSBC is set to emerge a winner

HSBC continued to perform well in the third quarter, confirming our thesis that it will be among the winners as we emerge from the global financial crisis. We are leaving our 800p per share fair value estimate unchanged.

HSBC said that pretax profits for the third quarter were significantly ahead of those of the year-ago period, excluding accounting losses on changes in the fair value of the bank's debt. HSBC Finance, HSBC's US consumer lending arm, continued to report losses. However, its condition appears to have stabilised somewhat; the firm's loan-impairment charges fell compared with those of the second quarter, and it did not need a capital injection from its parent company. Across the global bank, loan-impairment charges fell, as markets stabilised and its worst consumer portfolios continued to run off. Asset growth was broadly flat, as growth in Asia was offset by run-off in the US, Latin America, and the Middle East. HSBC's Tier 1 ratio increased to 10.3% during the quarter, and we continue to have no capital worries about the bank.

Fair value estimate: 800p ¦ Fair value uncertainty: High ¦ Economic moat: Wide

Thesis
(Last updated 21-09-2009)

There's much to admire about HSBC, in our opinion, although the global bank has been humbled by the credit crisis. Its massive footprint allows it to offer services to global customers that few financial institutions can match. We think HSBC's tremendous reach, combined with its famous frugality and focus on efficiency, lends the firm a wide moat. While HSBC's recent US subprime stumbles raised some doubts about its ability to manage its far-flung network and deeply dented profits, we think the bank's moat remains intact. At the same time, we think near-term profitability is likely to be disappointing, as HSBC absorbs losses from its US personal financial services business, now in runoff, and as growth in Asia sputters.

HSBC traces its roots to 1865, when it was formed to facilitate trade between China and Europe. It has since become a dominant force in global banking. It is the world's largest deposit taker, with more than $1.1 trillion in customer deposits, and serves some 125 million retail and 2.8 million corporate customers. Much of this growth was driven by acquisitions. HSBC became a major competitor in continental Europe in 2000, when it acquired France's Credit Commercial, and in the US mortgage market in 2002, when it acquired Household. HSBC is now focused on growing in emerging markets like Asia, Eastern Europe, and Latin America, which we think will deliver highly profitable growth for years to come.

HSBC's recent stumble with Household, which suffered deep losses in the US mortgage crisis and was shuttered in 2009, demonstrates the inherent difficulty in managing disparate operations. When HSBC acquired Household in 2002, it trumpeted the firm's risk-modeling systems, which it anticipated would enable it to judge the riskiness of loans more accurately than competitors could. As it turned out, HSBC placed too much faith in its newly acquired expertise and failed to adequately supervise its US managers. It has since admitted that the acquisition was a mistake--and a very costly one at that.

HSBC's strategy is now focused on winding down, and containing losses in, its US personal financial services business and instead focusing on customers that value its global reach and interconnectivity. The bank also plans to capitalise on its status as one of the world's strongest global banks, perhaps acquiring subsidiaries from struggling rivals. HSBC is especially focused on fast-growing markets, especially the Asian emerging economies. While we like this strategy, as we think it plays to HSBC's strengths, we also see it as risky--deeper-than-expected slowdowns in these regions could leave HSBC with an even bigger mess on its hands. Despite these risks, we remain optimistic that HSBC is up to the challenge.

Valuation
We have raised our fair value for HSBC by 50p to 800p as we adjust for the positive impact of reducing our cost of capital to 11% from 11.5%, our improved outlook and income accrued since our last update, and for the negative effect of exchange-rate movements. We assume that assets will shrink 5% in 2009 as HSBC runs off its US business, and grow an average of 7% annually between 2011 and 2013. We expect net interest margins to average 2.0% through 2013, above 2008's 1.8% low but below the 2.5% average between 2004 and 2007. We project that loan-loss provisions will increase to 3% of loans in 2010 but will fall to 1.2% by 2013, slightly above the historical average. We expect noninterest income growth to average 7% annually, and HSBC's efficiency ratio--operating costs/net revenue--to hover around 48%. We expect HSBC's profitability to be below its cost of equity in 2009 but expect return on equity to increase to 17% by 2013, around the bank's long-run average. Using these assumptions, we estimate a fair value of $13 per common share. We assume a fixed exchange rate of $1.63 per pound as of Sept. 18.

Risk
HSBC is exposed to nearly every economy in the world and the global slowdown is negatively affecting its results. For now, bad debt charges in personal finance, especially in North America, are driving HSBC's credit losses, but these should subside as HSBC Finance winds down. Future risks may lie in Asia and emerging markets, where growth has slowed and credit quality is dropping. Provisions for loan losses ate up 40% of income in the first half of 2009 and losses are likely to continue to depress profitability.

Management & Stewardship
We're impressed by HSBC's strong management team and are pleased with the steps it is taking to address some of our quibbles with its corporate governance. Stephen Green, who had been CEO since 2003, replaced legendary John Bond as chairman in May 2006, and Michael Geoghegan replaced Green as CEO. Both were long-standing HSBC veterans, and we don't expect to see a major strategy shift as a result of the transition. We think they make a good team; we like how Green's strategic thinking balances Geoghegan's aggressive style. In 2008, HSBC announced that three of its long-standing outside directors would be replaced by two new ones. We think this will enhance the board's objectivity, although we continue to see HSBC's 21-member board as unwieldy. HSBC announced a new executive pay plan in 2008. While we're pleased to see that pay will largely be based on measurable, long-term performance goals, such as earnings-per-share growth and total shareholder return relative to HSBC's peers, we're concerned that the size of the potential payouts is excessive. We also question the peers against which HSBC measures its performance, many of which have little emerging-market exposure. HSBC has said that it is likely to update the list.

Overview
Growth: HSBC's asset growth averaged 20% over the past five years because of acquisitions and internal growth. We expect growth to be negative in 2009 before returning to a long-run average of 7% annually.

Profitability: HSBC's return on average assets rose above 1% in 2004 and 2005 as the good times rolled and the bank boosted leverage. ROAA fell to just 0.3% in 2008, largely because of US subprime losses. We expect profitability to be depressed again in 2009 as loan losses and asset write-downs eat into profits, but to return to 1% in 2011.

Financial Health: HSBC's rights offering boosted Tier 1 capital to 10.1% as of June 30, 2009. While we think this is probably enough to get HSBC through the global recession, it has significant exposure to souring assets around the world. A prolonged downturn, or very slow growth in China, could put pressure on HSBC's capital ratios.

Profile: London-based HSBC has more than 10,000 offices in 86 countries and is among the largest banks in the world. It operates in Europe (55% of assets), North America (20%), Hong Kong (17%), other Asia Pacific (9%), and Latin America (4%). HSBC is principally a retail bank, with personal financial services accounting for more than 50% of operating income before loan-loss provisions. Global banking and markets and commercial banking account for another 19% and 21%, respectively.

Strategy: "The World's Largest Local Bank" is retooling its strategy to focus on expanding in fast-growing emerging markets and serving customers in mature markets that value HSBC's global reach. As part of this effort, HSBC is rapidly expanding its insurance and private banking businesses. In the United States, where HSBC took large losses on mortgage lending, it is closing its large consumer finance business. HSBC targets a return on equity of 15% to 19%.

Bulls Say
1. Aggressively promoting a single brand and logo and winning several awards has increased HSBC's brand awareness among corporate and retail clients.

2. The benefits of the bank's geographic diversification were highlighted during the financial crisis. Although the bank took large losses in its North American segment, the bank's Hong Kong, Asian, and European operations picked up the slack and the bank fared much better than most of its competitors in Europe and North America.

3. HSBC's exposure to the fastest-growing economies and wealth-creating regions ensures robust demand for its varied products and services, from checking accounts to wealth management.

4. A strong presence in Hong Kong and China makes HSBC the bank of choice for multinational companies that trade a lot with China.

5. Management compensation incentives ensure a focus on economic profits, cost control, and total shareholder returns, making HSBC shares attractive to own.

Bears Say
1. HSBC's profitability could suffer a setback if China abandons the "one nation, two systems" policy in governing Hong Kong.

2. Operating in developing countries exposes HSBC to above-average credit risk. Charge-offs in emerging markets have begun to rise and a global meltdown could cause a spike in loan write-downs.

3. HSBC underestimated the losses it would suffer in its subprime mortgage portfolio by billions. As this portfolio goes in to runoff, HSBC will be forced to inject additional capital into its U.S. subsidiary, taking it away from the rest of the bank.