HSBC’s China Focus Continues To Drive Profits, But Leaves The Bank Vulnerable To Trade War

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HSBC (NYSE:HSBC) reported a strong performance for the second quarter of 2018 earlier this week, with strong loan growth across its operating divisions coupled with upbeat capital market conditions driving the top line even as lower operating costs boosted profits for the period. We have summarized HSBC’s Q2 earnings and also detailed the major takeaways from the announcement in our interactive dashboard on HSBC’s Q2 earnings takeaways, the key parts of which are captured in the charts below.

As has been the trend over recent quarters, HSBC’s revenues continue to improve primarily due to the bank’s decision to focus on Asia – especially in the rapidly developing Pearl River Delta region in China. This has helped HSBC’s retail and wealth management operations as well as commercial banking operations in Asia. More importantly, as the bank’s operations in Asia have a notably higher profit margin compared to its operations in Europe and North America, this had a strong positive impact on the bottom line for Q2 2018. With the cost-to-income figure falling to just 60% for the quarter, HSBC’s Q2 net income figure jumped to the highest level since Q3 2015.

While HSBC’s strategy will be critical to its long-term growth, it presents a sizable downside risk in the event of a full-blown trade war. This is because HSBC has chosen to reduce its presence in North America and Europe over the years, and a trade war could trigger losses on a chunk of its retail and commercial loan portfolio in China while also weighing on overall revenue growth.

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That said, we believe that these economic headwinds can only have a small- to medium-term impact on HSBC’s value, and stick to our $56 price estimate for HSBC’s shares, which is about 20% ahead of the current market price.

See our full analysis of HSBC

Steady Growth in Outstanding Loans Mitigated by Negative Currency Movement

HSBC reported net consumer loans outstanding of $973 billion at the end of Q2 2018 – a 6% increase from $920 billion at the end of Q2 2017, but a small decline from the $981 billion figure in the previous quarter. The sequential decline can be attributed primarily to negative exchange rate movements, as a strong dollar over the period resulted in a reduction in HSBC’s portfolio of foreign loans in U.S. Dollar terms (as the bank reports results in USD).

However, adjusting for currency fluctuations, the loan base swelled sequentially due to strong lending gains in Asia followed by modest gains in Europe. More importantly, this growth did not come at the expense of higher loan losses, as loan provisions remained low for a second consecutive quarter, as shown in the chart below. This helped revenue growth from the larger loan portfolio accrue almost completely to the bottom line.

The Investment Banking Arm Could Have Done Better, Though

While HSBC’s business model is anchored by its retail and commercial banking operations, its investment banking arm remains a key revenue driver – especially given the bank’s strong presence in the global debt capital markets. HSBC reports the performance of its investment banking operations along with its treasury and securities services operations as a part of its Global Banking & Markets business division. This division reported revenues of $4.15 billion in Q2 2018 – 10% above the figure for Q2 2017, and almost identical to the figure for the previous quarter. However, the strong showing this time around was almost completely due to HSBC’s Global Liquidity and Cash Management division, thanks to its Asia focus.

The investment banking arm (securities trading and advisory & underwriting services) reported a reduction in revenues from $2.9 billion in Q2 2017 as well as Q1 2018 to below $2.7 billion in Q2 2018. This was much lower than expected, given that an increase in volatility drove securities trading activity higher in Q2 – helping most major investment banks report a 5-10% increase in securities trading revenues year-on-year. In contrast, HSBC’s securities trading revenues slipped from $2.1 billion a year ago to just $1.6 billion now. Although an increase in advisory & underwriting fees helped the top line partially, the weak trading performance resulted in total investment banking revenues falling to less than 20% of HSBC’s total revenues.

We expect HSBC to report an adjusted EPS figure of around $0.75 per common share for full-year 2018. Taking into account the fact that each HSBC ADR is equivalent to 5 common shares, and using a P/E ratio of 15 (which we believe is appropriate for the diversified banking giant), this works out to a price estimate of $56 for HSBC’s shares, which is about 20% ahead of the current market price.

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