HSBC - Further write down

HSBC announced that it will stop writing new business for its Consumer Lending business at HSBC Finance, where it had $62bn of outstanding loans at 4Q08. We remodel HSBC Holdings with a smaller operation at HSBC Finance. In 2008, HSBC reported a significant decline in capital due to mark downs taken to equity, where we show the implications should this persist. On our new forecasts, we are $2-3bn lower per annum on 2010 and 2011 estimates. We maintain our price to tangible book target at 0.7x, but on new forecasts, this results in a HK$28 target. Reiterate our SELL recommendation.

We doubt that all Consumer Lending debtors of HSBC Finance will repay their $62bn of loans. Given the fact that HSBC has taken the Goodwill charge for Household there is clear recognition of lack of value in this company and we believe, by association, in the loan book of this company. We believe that these assets will be partially marked down and likely taken straight to equity. All indications in the US are for continued high charges in N America, too.

HSBC’s results were illustrative of banking leverage risk as asset values decline. Its shareholders’ equity declined from $135bn to $100bn from securities mark downs, but also FX translation losses. Our view is that economies will deteriorate in 2009 vs 2008 and not be particularly strong in2010. The risk is therefore of more marks to equity. Even with mark downs50% less than 08A during 2009, it is possible that HSBC sees no book value improvement.

We have remodelled each region following the results announcement on Monday. While we do not replicate trading losses in forecasts years, we also do not replicated capital gains. Fundamentally we assume sharper rises in provisions in Asia, HK and South America and more subdued fee income and operating costs. We have though assumed better loan pricing in most regions. The net result is a $2-3bn reduction in 10CL-11CL per annum.

Where asset valuation is held in question, price to tangible book is more relevant. Including $17bn of new equity for HSBC and a further dividend cut, price to tangible book is 1.0x now, giving 38% downside to 0.7x.

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HSBC: Possible 2-for-5 rights issue

According to media in the UK and US, HSBC will announce a 2-for-5 rights issue today upon the announcement of its 2008 results. Assuming the subscription price for the rights issue is HK$27.50/share, representing c. 50% discount to last Friday's closing in Hong Kong. The rights issue plan should enable the Group to raise as much as US$17bn (Pound12bn). The offering is said being underwritten by Goldman Sachs and JP Morgan Cazenove.

The media also mentioned that HSBC will make Pound17bn (US$24.3bn) total provision for the Group in 2008 (similar to our forecast of US$23.7bn). It is also said about two-third of the provision charge (i.e. US$16bn) is expected to come from HSBC Finance (formerly Household International), which is similar to our forecast of US$15.3bn. In addition, HSBC is said to make Pound7bn (US$10bn) goodwill write-off on HSBC Finance and that large parts of HSBC Finance's operations will be closed and almost all the value attributed to the business will be wiped out. The sources also said HSBC will cut its DPS by 30% (not mentioned about if 2008 and/or 2009), compared with our forecasts of 28% y-o-y decline in DPS to US$0.65/share for 2008 and 17% y-o-y decline in DPS to US$0.54/share for 2009.

Assuming the above details are correct, we estimate that the rights issue will be earnings and book value dilutive. BVPS (Dec-09F) will be reduced by 20% to HK$69.80/share from HK$86.80/share while its EPS for 2009 will also be decreased by c. 20% to HK$4.64/share from HK$5.98/share. Its tier I CAR (Dec-09F) will be raised to 10.2% from 8.9%. This will put HSBC's tier I CAR at the higher end of global bank peers (ranging from 7.3-11.9%) from the middle of global bank peers' range.

We believe the rights issue will remove the short-term overhang about the rights issue concern by investors. While the rights issue can strengthen its capital positions, we believe HSBC's earnings outlook remains uncertain and earnings visibility remains low. Not only earnings from developed countries are slowing down but also the earnings momentum of emerging markets are seeing challenges ahead. With more banks peers being nationalized or injected capital from governments, privately owned banks like HSBC may still be marginalized although it strengthens its capital base. Moreover, HSBC is difficult to be re-rated, given its P/B is already at decent premium to peers (57% to UK banks, 30% premium to US banks and 55% to European). HSBC's share price will continue to be dragged by their weak price performances of those global banking peers on deepening of the financial tsunami and the looming risks in Eastern Europe.

Subject to further details of the rights issue and 2008 results, we temporarily peg our 2009 target P/B at 0.75x which translates into a 12-month target price of only HK$52.30/share (original: HK$60.00). Hence, we believe there may be some "short-term" rise in HSBC's share price on covering of short positions by some investors while the overhang about rights issue is removed. However, after the "short-term" rise, HSBC's share price may still be under pressure.

Hong Kong Bank - Set for an Even Tougher 2009

The operating environment for Hong Kong banks is likely to worsen in 2009 as the rising corporate failures, particularly SMEs and export related sectors, will result in higher credit cost for banks. We expect to see limited loan growth and lower NIM as banks are both cautious in lending as well as deploying the excessive funds in higher yielding products.

The fee income, one of the growth engines for HK banks' earnings in the past, will disappear as stock brokerage income and wealth management product sales worsen in a contracting economy.

Besides earnings deterioration, Hong Kong banks are also subject to further write-down from its investment portfolio where a lot of their excess liquidity was placed in overseas investments and the market bond prices deterioration will result in significant book value erosion.

Hang Seng Bank: In our view, HSB is less likely to cut the dividend since the bank had a good track record of paying out stable dividend on a progressive DPS policy – HSB did not cut its dividend during the Asian crisis. Moreover, HSB has in the past paid out over 100% of earnings as dividends – in 1999 and 2002, HSB has paid out dividends more than the earnings (e.g., retained earnings) during those years as the payout ratio was 189% and 104%, respectively.

BOCHK: BOCHK pays dividends based on payout ratio policy. Since its listing in 2002, the bank has maintained a stable dividend payout ratio of about 60-70%. A cut to the payout ratio is unlikely, but BOCHK's DPS will be more sensitive to changes to earnings. That said BOCHK is one of the best positioned banks in the sector in terms of capital strength. Its tier 1 ratio of 11.5% in 1H08 ranked high as compared with the sector average of 10.2%. In our view, both BOCHK and HSB have the capacity to raise tier 2 even under the current environment. Recently, to beef up its capital amid the current financial crisis, BOCHK has tapped in tier 2 funding of US$2.5bn from its parent at lower than market interest cost.

Bank of East Asia: BEA also pays dividends based on a payout ratio, but we believe the bank is susceptible to a dividend cut in this downturn given high earnings uncertainty. Due to relatively low profitability, the bank has a high sensitivity to bad debt provisions in a rising credit risk environment. As compared with peers, its balance sheet is relatively stretched due to its strong growth in China in recent years. Its tier 1 ratio of 9.4% falls at the lower end of the sector's average.