HBCYF - HSBC: With Earnings Set To Peak Time To Sell

2023-09-12 06:48:51 ET

Summary

• We believe HSBC's earnings will peak in FY12/2023 and the bank is expected to face increasing credit risk in China and the UK markets.
• Exposure to China's real estate sector and the UK mortgage market is an ongoing concern.
• There is a risk that the market is underestimating credit risk and overestimating loan growth, and we expect the bank's earnings growth to significantly decelerate.

Investment thesis

After benefitting from interest rate hikes driving net interest income growth, we believe HSBC (HSBC) will have to deal with increasing credit risk in China and the UK markets, as well as falling loan growth. With earnings peaking in FY12/2023, we are lowering our rating from neutral to sell.

Quick primer

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 the UK, Asia, the Middle East, and North America.

Key financials with consensus forecasts

Sales split by business segment under constant currency YoY - H1 FY12/2023

Profit before tax split by business segment under constant currency YoY - H1 FY12/2023

Updating our view post accelerated interest rate hikes

We are updating our view from October 2022. With earnings peaking in FY12/2023 we are lowering our rating from neutral to sell. We have missed a 40% upward move on the shares, with the primary concern having been the state of the UK economy based on the erratic moves made by the then Chancellor of the Exchequer Kwasi Kwarteng .

With the Federal Reserve raising rates 11 times since 2022, and the Bank of England raising 14 times since December 2021, profitability in the banking sector rocketed up with the increase in net interest margin (please see Key financials table above). HSBC booked net interest income growth of 38% YoY in H1 FY12/2023 ( page 9 ), but the most recent results indicated that the bank may face headwinds going forward. Credit costs increased from USD1.3bn to USD1.1bn YoY (+18% YoY), due to the weakening commercial real estate sector in mainland China as well as commercial banking in the UK. The underlying loan book growth was effectively flat YoY, as well as 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 the recent positive performance is sustainable and whether management is being opportunistic over shareholder returns.

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

With the recent press attention over the state of China's real estate sector, it did come as a slight surprise with management commenting in August 2023 that the 'mainland China commercial real estate market showed signs of recovery and stabilization in early 2023' (page 27 of H1 report). Recent newsflow indicates continued difficulty in leasing office buildings , and although HSBC has been cutting exposure to Chinese commercial real estate it still has USD 13.2 billion in Hong Kong and the mainland combined (page 16 of H1 report). Even if some of the loans are secured, we expect property valuations to fall with weakening demand. We believe conditions will worsen into H2 FY12/2023, resulting in increasing credit losses.

To date, HSBC has experienced limited signs of stress in the UK mortgage market. However, mortgage customers are due to roll off fixed-term deals during FY12/2023 and FY12/2024, and further rate rises are expected. This could result in a negative event with increasing delinquencies, at a time when UK home values are also falling . Although calling it a ' mortgage time bomb ' may be overdramatic, there is a sense that risks are on the downside for the UK personal banking business.

Looking at consensus forecasts, we believe that there is also a risk that the market is downplaying credit risk with FY12/2023 total loan loss provisions expected to decline 7.9% YoY (see table above). With the current economic climate, we expect loss provisions to increase YoY.

Expectations point to an unsustainable trend

With consensus estimating FY12/2023 reported EPS to grow by 80.8% YoY, it feels inevitable that earnings growth will decelerate significantly YoY. We observe that the market expects steady long growth into FY12/2024 (+2.9% YoY) and FY12/2025 (a strengthening trend at +3.6% YoY), which we believe to be too positive given the state of current demand, and the increased financing costs associated with the rate hikes. Loan loss provisions are set to remain relatively stable at under 0.4% of the loan book - this could also be too bullish given the state of the general economy, and the rise in consumer debt particularly for credit cards in the US and UK . The company has a detailed analysis of how it has calculated its credit cost requirements (pages 69 to 77 of the H1 report), but we believe that current assumptions are too conservative.

What does seem realistic is consensus forecasts for dividends, with a decline YoY estimated into FY12/2025 as earnings go into negative growth. We believe this indicates that the relatively easy period of capitalizing on interest hikes for net interest income will soon end, whilst demand for loan growth will remain relatively weak.

Valuation

With consensus forecasts expecting flat to falling reported earnings growth as well as dividends for the next two years, we believe this is a negative signal. The implied dividend yield of 14.8% in FY12/2024 is high and attractive, but we believe there is downside risk to this given consensus assumptions over loan growth, and credit costs.

Thesis Catalysts

HSBC is aiming to keep shareholders onside with increasing returns, and despite fundamentals weakening there may be sustained high dividends and buyback activity. If 12 months down the line the Chinese economy experiences a major recovery, the bank is positioned for growth.

Risks To The Thesis

Downside risk comes from underestimating credit risk in China and the UK markets. Weakening fundamentals may result in the bank being unable to sustain high levels of shareholder returns.

Conclusion

We missed the upswing in the shares from late 2022 but felt that the banking sector generally was a place to be overweight as opposed to HSBC specifically. Although HSBC has performed in line with top sector peers such as JPMorgan (JPM) and outperformed the likes of Standard Chartered (SCBFF) over the last 12 months, we believe that the 'easy money' period is over, and credit risk will have to be dealt with. We are lowering our rating from neutral to sell.

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