Analysts have upgraded HSBC to £8.80 per share from £7.04 following a solid third-quarter result. The bank is currently trading at £6.34 making it undervalued – considered a four-star stock by Morningstar equity analysts.
There is no change to the narrow economic moat rating, meaning analysts consider it have a small and stable competitive advantage over banking peers. The bank maintains a dominant position in Hong Kong and benefits from funding cost advantage with deposit market share of 20%.
HSBC’s (HSBA) strengths are its positions in the U.K. and Hong Kong banking systems, as well as its overall leadership role in trade finance. With China, Hong Kong, and Singapore being important pools of wealth and growing trade corridors, the bank’s pivot toward Asia – about 75% of pre-tax income – makes sense.
The focus is on deepening relationships with customers across its existing geographies and leveraging the bank’s international network in bringing in new clients. HSBC’s banking network serves 90% of global trade and about 40% of the bank’s revenue.
The broad geographic nature of its business model results in reduced pre-tax profit volatility versus peers, as evident during the global financial crisis, but comes with higher capital requirements. Due to its status as a global systematically important bank, HSBC is one of three banks required to hold extra capital buffer of 2%.
Over the past few years, the bank has undertaken a largely successful restructuring and has exited unprofitable markets and low-returning portfolios, reducing total risk-weighted assets by about $296 billion.
A focus on reducing costs, a straightforward plan in a low-interest-rate environment, has stripped out about $6 billion in costs via headcount reductions, procurement efficiencies, and various digital initiatives. With U.S. interest rates increasing recently, the bank is now poised to reap the benefits of its leaner structure.
We also like the bank’s pivot toward Asia, as it takes advantage of HSBC’s strengths. The region is growing in terms of importance for global trade, increased urbanization, and a growing middle class. The bank’s strengths in Hong Kong position it well to take advantage of growth in the Pearl River Delta, and the leading international bank in China.
The latter is achieved through the bank’s long operational history and investments in China. As a result, HSBC is well positioned to capture economic growth in asset management, Chinese yuan internationalisation, and consumer and corporate lending.
Return on Equity to Improve
A higher level of operating expense was a key concern last quarter against management guidance for a positive jaws ratio – when a company’s income growth exceeds its expenses growth. Positively, the jaws ratio narrowed to negative 1.6% for the nine months from negative 5.6% at the first half.
The near-term operational improvement is certainly a positive and we expect this to continue as the bank is operating on a leaner structure after its restructuring. We expect the bank’s return on equity to steadily improve in the medium term in the context of an improving operating environment, as reflected in rising interest rates globally and third-quarter loan growth of 2% on last quarter, or 6% on the end of last year.
Trade War Impact Limited
The bank’s U.K. deposit market share is also in line with peers and its competitive position is strong. Our uncertainty rating is revised to high from medium, in line with global peers under our coverage with extensive exposure to global economic conditions. The trade tension is a near-term headwind but the bank is not seeing any negative impact on credit quality.
Given the bank’s strong capital position, we expect the impact from an escalation of trade tension is limited to profitability.
Rising Interest Rates a Positive
Rising interest rates remain a key positive tailwind for the bank. Generally, banks in Hong Kong have competed aggressively in mortgages given the higher profitability and the low interest rate environment means banks in general can borrow cheaply. Given HSBC’s strong deposit market share, we expect the bank to fare better than peers as funding costs increase.
We expect banks more reliant on wholesale funding to compete less aggressively as funding costs increase and this may ease the pressure on mortgage margins in the near term.
