HSBC: Earnings Peak, Time to Sell (OTCMKTS:HBCYF)

Investment Thesis

After benefiting from interest rate hikes fueling net interest income growth, we believe HSBC (NYSE:HSBC) will face rising credit risk, as well as declines in China and UK markets debt increase. With earnings peaking in FY12/2023, we are downgrading our rating from Neutral to Sell.

A quick primer

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

Major financials with consensus estimates

Breakdown of sales by business segment under constant currency YoY – H1 FY12/2023

Profit before tax breakdown by business segment under constant currency YoY – H1 FY12/2023

Updating our view after interest rate hikes

We are updating our approach from October 2022 onwards. We are downgrading our rating from Neutral to Sell as earnings peak in FY12/2023. We have missed the 40% upside move in shares with the UK economy being the primary concern based on erratic moves by then Chancellor Kwasi Kwarteng.

With the Federal Reserve raising rates 11 times from 2022 and the Bank of England raising rates 14 times from December 2021, the increase in net interest margins boosted profitability in the banking sector (please see key financial table above). HSBC reported 38% year-on-year net interest income growth in H1 FY12/2023 (page 9), but the most recent results indicated the bank may face headwinds going forward. Credit costs increased from USD1.3bn to USD1.1bn YoY (+18% YoY) due to a weaker commercial real estate sector in mainland China as well as commercial banking in the UK. Underlying loan book growth was effectively flat YoY, as were customer deposits (page 1 of the H1 report).

Management has focused on cost control and increasing total shareholder returns in the form of increasing dividends and a USD 2 billion share buyback program. We want to assess whether recent positive performance is sustainable and whether management is opportunistic relative to shareholder returns.

Our concerns for the short-term – China real estate and UK NPLs

After recent press attention on the state of China’s real estate sector, it was little surprise that management commented in August 2023 that ‘the mainland China commercial real estate market showed signs of recovery and stabilization in early 2023’ (page 27 H1 report). Recent newsflows indicate that leasing of office buildings continues to be difficult, and although HSBC is reducing its exposure to China commercial real estate, Hong Kong and the mainland combined hold USD 13.2 billion (page 16 of the H1 report). Although some loans have been securitized, we expect asset valuations to decline due to reduced demand. We believe the situation will worsen in H2 FY12/2023, resulting in higher credit losses.

To date, HSBC has experienced limited signs of stress in the UK mortgage market. However, mortgage customers will be taking out fixed-term deals in FY12/2023 and FY12/2024 and further rate hikes are expected. While this could also lead to a fall in UK house values, it could have a negative effect with rising crime. Although it may be overdramatic to call this a ‘mortgage time bomb’, there is a sense that the risks are low for the UK personal banking business.

Looking at consensus estimates, we believe the market is discounting credit risk with total loan loss provisions expected to decline by 7.9% for FY12/2023 (see chart above). In the current economic environment, we expect loss provisions to increase during the year.

Expectations point to an unsustainable trend

With consensus estimates for EPS to grow by 80.8% YoY in FY12/2023, it seems inevitable that earnings growth will decelerate significantly year-on-year. We see a prolonged market growth expected in FY12/2024 (+2.9% YoY) and FY12/2025 (+3.6% YoY with a strengthening trend), which we believe is very positive due to the current demand scenario, and growth associated with rate hikes. Financing costs. Loan loss provisions are set to remain relatively stable at under 0.4% of the loan book – this could also be very bullish given the state of the general economy and the growth in consumer debt for credit cards in the US and UK in particular. The company has analyzed in detail how it calculated its credit cost requirements (pages 69 to 77 of the H1 report), but we believe the current assumptions are too conservative.

What seems realistic is the consensus forecast for the dividend, with earnings heading to negative growth, with the annual forecast falling in FY12/2025. We believe this suggests that the period of relatively easy capitalization of interest rate hikes to net interest income will soon end, while demand for loan growth will remain relatively weak.

evaluation

We believe this is a negative signal, given consensus estimates for earnings growth as well as dividend expectations for the next two years. The implied dividend yield of 14.8% in FY12/2024 is high and attractive, but we believe there is downside to all these consensus assumptions on debt growth and credit costs.

Thesis catalyst

HSBC aims to sideline shareholders with growing returns, and high dividends and buyback activity may persist despite weakening fundamentals. If there is a major recovery in China’s economy 12 months from now, the bank is positioned for growth.

Risk to the thesis

Underestimating credit risk in China and UK markets leads to downside risk. Banks cannot sustain high levels of shareholder returns due to weak fundamentals.

conclusion

We missed the upside in shares in late 2022 but felt the banking sector was generally overweight against HSBC in particular. While HSBC has outperformed top sector peers such as JPMorgan ( JPM ) and outperformed Standard Chartered ( OTCPK:SCBFF ) over the past 12 months, we believe the ‘easy money’ period is over and credit risk will ease. have to face. We are downgrading our rating from Neutral to Sell.

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