Is HSBC’s 7% dividend yield too good to be true?

HSBC (HSBA) was one hundred and fifty years old in 2015. It has celebrated its birthday by putting in place capital rejuvenation plans through a restructuring, which last year produced an extra $11.3 billion of capital with which to improve capital ratios and increase the dividend.

This year will see more restructuring costs, and bumps from China’s economic slowdown, no doubt. However, the bank also identifies growth spots, as outlined in this note. As a bank, HSBC will not find it politically or socially easy to cut its dividend.

The increased annual dividend was a good portent. HSBC is one of the best bets in town on a company paying the same dividend again next year, even when the dividend yield is 7.48%, suggesting that the market thinks it is most likely to be cut.

Were HSBC annual results for the year to December 31^st 2015 good or bad? The market’s initial reaction was to mark the shares down strongly; but they recovered to being only one per cent off after fuller consideration.

On the understanding that everything is relative – unless you are the Pope – these were good results given that 2015 was the year of a historic collapse in metals and oil prices, an equally historic plunge in interest rates and troubles in China and its trading partners in Asia. On top of this came the significant costs in relation to beefing up its compliance resources, in the wake of a pretty horrible period of legal and regulatory fines, penalties and settlements for bad conduct. You might reasonably have entertained fears of a dividend cut in such a year; but as it turned out, the annual dividend payout was actually raised for 2015, albeit by only two per cent, from fifty cents to fifty one cents – but raised nonetheless! It was pointed out that growth in the dividend would depend on long-term profitability. Not exactly a revelation!

Top line revenue was up one per cent. The reported profit before tax figure came in as actually up one per cent, to $18,867 million; however after company adjustments to give a better underlying and more consistent basis of comparison, the HSBC annual profit before tax was down seven per cent for the year as a whole. When I last wrote in November following the third-quarter results, the market consensus was for an increase in underlying earnings per share in 2015.

A passing analysis of the reasons for profits being lower than the market had earlier estimated must include the substantial seventeen per cent increase in the bank’s estimates of bad and doubtful debts (that being after the company had hacked out a lot of riskier business – the figure is a stated $3,721 million).

There was also a five per cent increase in operating costs due in part to increased compliance costs and the necessity of increasing the headcount by an extra two thousand five hundred (a small army). That brings such hiring over the past five years to an additional seven thousand individuals (an even larger small army of people to try and make sure that the bank stays within the boundaries of ethics, regulation and laws in numerous jurisdictions, but particularly in the USA).

There were also the restructuring costs of reducing the size of the bank’s operations in order to reduce the ballast of risk weighted capital it has to carry. It was reported that ‘risk weighted assets’, or ‘ RWAs’, had been pruned a massive $124 billion, and that HSBC had completed forty five per cent of the reduction in the bank’s risk weighted assets planned to be completed by the end of next year. So, we are just over the top of the hill in the costs of achieving that target, which means that this year and next will probably continue to see such restructuring. The greater capital efficiency of the bank is to be seen in the improvement in the Tier 1capital ratio which had risen to 11.9% from 11.1% the previous year.

Essentially then, we should not just see these results as a snap-shot of normal, trading, but also in the context of significant change in the bank’s structure and assets. The bank has been shrinking itself to reduce its exposure to regulatory risk. As part of that, it has sold its Brazilian business and attempted to sell its Turkish business but evidently failing to accomplish that objective (it is now to be restructured, no doubt adding to restructuring costs, which last year totalled a reported $117 million for the Group). The reorganisation cost of global banking was $172 million and the cost to ring fence the deposit taking bank from the rest of the investment bank was a cool $98 million. The biggest cost was for the settlement of legal and regulatory charges and obligations which incurred an additional, overshadowing $1,649 million of costs. There was also a figure of $541 million for what was described as reimbursement of UK customers.

The optimistic view of the future should include the fact that the bank plays a role in the internationalisation of China’s currency, the Remnimbi and that HSBC has negotiated a joint venture deal in Chinese securities trading which, once final approval is granted, will be what they describe as a landmark opportunity in China’s capital markets. The bank describes itself as the leading bank in Remnimbi financial transactions. More generally, the CEO summarised the outlook as follows:

“HSBC is better balanced, better connected and better placed to capitalise on higher return businesses than it was 12 months ago. Our universal banking model is generating higher income from collaboration between businesses and our operating expenses and capital ratio are trending in the right direction. Maintaining these trends while boosting revenue will be the principal challenge in the year ahead.

The current economic environment is uncertain, but our diversified banking model, low earnings volatility and strong capital generation give us strength and resilience that will stand us in good stead. We remain focused on delivering our nine remaining strategic conditions by the end of 2017.”

China still has the potential to give the bank a bumpy ride as the economy is refocused towards value-added consumer-led activities. However, the management of HSBC points out that China will remain the biggest contributor towards global growth this year. Amongst a number of economic and commercial growth spots, it identifies the brand new Trans Pacific Trading Partnership signed this month as having the potential for significant economic stimulus. They also point to the financing need for infrastructure spending as a result of climate change, with much activity centred on “Green Bonds” as well more PPFI lending in Europe.

The investment attractions of HSBC include the following: HSBC shares stand at a near thirty per cent discount to assets; the dividend was increased to 51 cents at a time of Sterling weakness; and, if HSBC merely maintains the dividend next year at 33.75p, on a share price of 451p (last seen) the prospective dividend yield would be nearly 7.5%, which is consistent with the share price’s hefty discount to net asset value.

Subject to Chinese bumps next year, I think that there is a sporting chance of the dividend being maintained if legal costs etc. start to come down. The shares are just above being the cheapest they have been for five years. They may not be discounting everything, but they are self evidently discounting a lot. However, the mood remains bearish and the share price chart is heading downwards. There is no likely near-term bullish news to appear out of the woodwork.