HSBC: Downgrading Our View Due To Inflationary Pressures

HSBC: Downgrading Our View Due To Inflationary Pressures

Investment thesis

The shares have performed well since our August 2021 review, and we are downgrading our view from buy to hold. Current consensus forecasts look too positive given the lack of loan book growth and the escalating challenges over a persistent inflationary environment. The current dividend yield of 5.6% is not unattractive, but at this level we believe the shares are a hold.

Quick primer

HSBC (HSBC) is a global retail and commercial bank with the UK and Hong Kong as its home markets. Its core franchise is in trade finance, which supports its corporate and investment banking operations. Its key geographic markets are UK, Asia, Middle East and North America.

Key financials

Profit before tax by region Q3 YTD FY12/2021

Profit before tax by segment Q3 YTD FY12/2021

Our objectives

We revisit our bullish view from August 2021 – in this piece we want to assess the following:

• with ECL (expected credit losses) being unwound, is there much more in terms of positive earnings surprises in the short term?
• shareholder returns have improved with the bank announcing a share buyback of up to $2 billion, equivalent to 1.2% yield. But with macroeconomic risks, will the bank in a position to sustain such returns?

We will take each one in turn.

Normalizing credit losses

Credit performance is improving as the impact of the pandemic softens YoY and HSBC managed a net release of $0.7 billion in ELC during Q3 FY12/2021 versus a charge of $0.8 billion in Q3 FY12/2020. Although this is not a huge surprise it is nevertheless a positive, helping to boost adjusted profit before tax by 36% YoY for the quarter. With a net release for ECL expected for FY12/2021, the bank expects a small release to follow QoQ with around $1.2 billion remaining of its Stage 1 and 2 allowances for bad debts made during 2020.

Looking at consensus forecasts for FY12/2022 and beyond we see that the market is already pricing in a normalization of loan loss provisions (see Key financials). The bank’s expectations are that ECL charges will normalise in the second half of FY12/2022. Consequently, we believe that this positive is priced into the shares and any further net releases will be seen as neutral and of limited impact to future earnings growth.

Whilst we are not complaining that asset quality is improving, we now see limited earnings upside from this theme and believe that the bank must now generate solid earnings growth from more everyday factors – continued cost reductions and growing its loan book. However, with inflationary cost pressures and rising rates that will drive financing costs up, we are less certain that this will be achievable. Net interest margins remained flat YoY at 1.19% for Q3 FY12/2021, highlighting that appetite for borrowing remains limited.

Maintaining earnings growth for sustainable returns will be difficult

Consensus forecasts are currently on a positive footing, with expectations of high single digit revenue growth YoY into FY12/2023 together with stable dividend growth. The outlook for rising global interest rates should allow net interest margins to rise, which is good news as long as borrowing levels remain flat or increase and asset quality remains firm.

The picture for loans and advances to customers in Q3 FY12/2021 was mixed, where the balance fell by $20 billion (-2% YoY). On a constant currency level the balance fell by $6 billion which is not a dramatic decline but nevertheless highlighted that record low borrowing rates were not driving demand for retail or commercial customers.

We look at HSBC’s two key geographic markets. Money statistics from the Hong Kong Monetatry Authority show that total loans and advances for December 2021 decreased by 0.8% YoY driven primarily by falling trade finance. In the UK, Bank of England reported that December 2021 saw seasonally adjusted annual growth of lending to SMEs and large business remain negative YoY, although large businesses were beginning to see signs of recovery. With regards to UK consumer lending, with well-documented rises in the cost of living through utility bill hikes (more than a third of Britons cannot afford to heat their home to a comfortable level), transport costs (train and bus fares in London will increase an overall average of 4.8%), tax hikes and continued difficulties as a result of Brexit raising prices, we believe borrowing will take a hit in FY12/2022 in terms of both loan growth and rising delinquencies.

We have a cautious view for how HSBC will perform in FY12/2022 and believe consensus estimates are too positive. The recent improvements in global economic performance come off a low base YoY. The combined impact of rising rates, fiscal tightening and a cost-of-living squeeze are not conducive to confidence and a growing loan book. Global markets are experiencing sell-offs which is negative for investment banking fees. All in all, we believe HSBC’s aim to grow will experience speed bumps which in turn will have a negative impact on the prospect of increasing shareholder returns.

Valuation

The shares are trading on consensus dividend yield of 6.6% for FY12/2022, which is an attractive yield. However, given the challenges facing the business we believe consensus estimates are too bullish. As a result we believe prospective dividends will be flat to up YoY as opposed to a robust 17.4% hike YoY. We expect a more realistic prospective dividend yield of approximately 5.7%.

Risks

Upside risk comes from HSBC being firmly committed to raising shareholder returns via dividends or buybacks, in spite of softer than expected business conditions in FY12/2022.

HSBC could also instigate further cost reduction measures in order to free up earnings available for distribution. Although the business portfolio has been reviewed, further asset sales of non-core businesses could free up capital for shareholders.

Downside risk comes from adverse macroeconomic conditions that result in low or no growth. This will place pressure on management to utilize capital to generate new avenues of growth that could cut back returns for shareholders.

Credit delinquencies may become higher than standard pre-pandemic levels as a result of high inflation. As salaries remain static there will be more pressure on debt defaults and deteriorating credit quality particularly in the UK.

Conclusion

The shares have performed since our August 2021 review, and we are downgrading our view from buy to hold. Whilst ECLs are being released and shareholder returns have improved, we did not previously take into account the challenges from a highly inflationary environment that does not look transient. Current consensus forecasts look misleading given that loan book growth is not recovering and without this HSBC’s earnings outlook remains challenged. The current dividend yield of 5.6% is not unattractive, but at this level we believe the shares are a hold.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Published at Tue, 15 Feb 2022 18:12:55 -0800