HSBC focused on fast growing markets

Following the announcement of the relocation of HSBC’s CEO to Hong Kong, we take a look at Morningstar stock analyst Erin Davis’ assessment of the banking giant’s UK-listed stock.

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

Analyst note
HSBC announced Friday that it plans to relocate the office of its CEO, Michael Geoghegan, to Hong Kong. While the move won't affect our fair value estimate, we see it as symbolic of the importance that the bank expects Asia to play in its future growth. Excluding losses from North America, China and Hong Kong accounted for nearly 40% of the group's profits in the first half of 2009, and we expect this figure to grow over the coming decade. HSBC has said that it wants to be the gateway to China and has been increasing its already strong presence in the region in recent years; this latest move underscores the emphasis HSBC is placing on its traditional home market. HSBC is also planning an initial public offering of its shares in the Shanghai market.

Thesis
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 U.S. 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 U.S. 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 U.S. 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 U.S. 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-modelling 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 U.S. 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 U.S. 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're raising 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 U.S. 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.

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%.

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.

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.

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 U.S. 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.