HSBC Shaping Up by Paring Down

HSBC (HBC) is showing excellent progress in implementing a new strategy announced in May 2011, and we expect this soon will be reflected in both the firm's results and stock price. The new "Five Filters" strategy directly addresses our biggest question about the firm: Is it too sprawling to manage effectively and efficiently? Put simply, HSBC is systematically examining whether individual business lines are sufficiently strategic and profitable, and shedding those that are not. By February 2012, the firm had announced the sale or closure of 19 businesses involving about 4% of the firm's employees, and has since announced four additional sales.

At the same time, we continue to see HSBC's strong capital and deposit base, its geographic diversity and exposure to growth markets, and its conservative business plan as especially attractive and unusual among European banks. While HSBC's stock has run up since its lows in late 2011, we still urge long-term investors to consider buying shares, now priced around 72% of our $60 fair value estimate and 1.0 times book value, ahead of HSBC's Investor Strategy Day on May 17, as we believe the firm is likely to announce additional progress on cutting costs and streamlining its business model.

Filtering Out the Failures
In May 2011, HSBC announced its new "Five Filters" strategy, which evaluates each of the firm's businesses against its core criteria of international connectivity, economic development, profitability, cost efficiency, and liquidity. The strategy gives the firm a systematic way of evaluating whether each of its individual business lines is sufficiently strategic and/or profitable to remain a part of the group. In practice, this means that management first asks whether a business is strategically relevant to the group: Does it support connectivity in economically important geographies, or is it located in an area with enough economic development to spur meaningful wealth creation? If these questions are answered with a resounding yes, management plans to either invest in these businesses (like commercial banking in Germany) or work to turn them around (like inefficient operations in France).

Businesses that are not particularly economically important are then divided into two categories--those that offer sufficiently attractive returns, and those that do not. Those that do will be allowed to continue as-is, and those that do not will be slated for disposal.

We think the new strategy will help HSBC resist its tendency to try to be everything to everyone, thereby essentially allowing its slogan, "The World's Global Bank," to become its de facto strategy. In practice, the new strategy means that HSBC dramatically will cut back on retail banking outside of the United Kingdom and Hong Kong, will exit 39 of its 61 retail markets, will standardize technology and processes in its corporate bank, and will pull back from some investment banking activities. Altogether, the group intends to cut about $3 billion of costs by 2013, including the $900 million cut in the six months since the strategy was announced. While HSBC's massive size means this will take some time, we think management's actions since its strategy was announced prove that it is serious about change; by February 2012, it had announced the sale or closure of 19 business lines affecting about 4% of the group's staff. In general, the businesses that HSBC is exiting are subscale, like retail banking in Russia, or nonstrategic and underperforming, like its cards and retail services business in the United States. At the same time, HSBC is investing in its core businesses by, for example, expanding its commercial banking presence in faster-growing markets.

We were pleased with the strategy when it was announced, as we think it is logical, clearly articulated, and focuses on building businesses around the source of HSBC's narrow moat--the interconnectivity and global reach of its corporate bank.

HSBC's Moat-Maker: International Corporate Customers
HSBC's commercial banking segment, along with its global banking and markets division, creates a global network to serve international companies that competing banks cannot match. Its strength in trade finance is widely recognized: HSBC is the number-one trade finance bank in the world, according to Oliver Wyman statistics, and in 2008-11 it was named "The Best Global Trade Finance Bank" by Global Trade Review Magazine. Also in 2011, HSBC was named "Best Trade Finance Bank in Asia-Pacific" by FinanceAsia for the 14th year in a row.

The global trade market is an estimated $10 trillion annually, and businesses in large part depend on financial intermediaries like HSBC--about 80% of international trade is supported by trade finance. Historically, banks like HSBC have served as a bridge between importers and exporters, with the importer's bank providing a letter of credit to the exporter and thereby providing assurance that the exporter will be paid for their goods. This somewhat cumbersome method of conducting business largely has been replaced by a system in which trade banks, for a fee and interest, provide actual financing for the transaction and not merely a guarantee. This business clearly plays to HSBC's strengths--global presence, solid reputation, and strong balance sheet.

Geographic Diversity Drives Growth
HSBC is the world's most geographically diversified bank as measured by both risk-weighted assets and pretax, pre-impairment profits. We think this balanced business plan will allow HSBC to grow despite headwinds in Europe and the U.S., as well as provide protection against further turmoil in Western Europe. Despite HSBC's London headquarters, only a quarter of the group's operations are located in Europe, while 35% of profits are derived from Hong Kong and Asia, 25% from North America, 13% from Latin America, and 5% from the Middle East and North Africa.

Moreover, we expect that HSBC's breadth will allow it to grow much faster than its peers. Growth in developing economies is expected to exceed 6% annually through 2016, while staying below 3% in advanced economies (and below 2% until 2013). Perhaps even more notably, emerging-market share of global GDP is expected to be more than 50% by 2013 and grow about 1% a year thereafter. HSBC's unrivaled global network means that it is likely to be a material beneficiary of this growth, while its deep roots in these markets, and especially in Asia, mean that HSBC is likely to be standing on the highest ground if growth should ebb.

While we believe that North America will remain a near-term drag on HSBC's earnings, we think that the risk of collateral damage to the rest of the group has been dramatically reduced. Most importantly, the run-off consumer and mortgage lending portfolio (responsible for about two thirds of the geography's loan losses) has been reduced by 48% since the beginning of 2009 to $49.5 billion. Notably, loan impairment charges in North America fell 16% in 2011 to the lowest levels since the subprime crisis began. We think that HSBC's new strategy will help to temper the growth in the region's operating expenses, which have increased because of higher regulatory and foreclosure expenses. In 2011, the group reached an agreement to sell 195 nonstrategic branches in upstate New York; it also reached an agreement to sell its card and retail services business. Both transactions are expected to close in 2012.

HSBC Deserves a Long-Term Look
We remain convinced that HSBC offers an attractive risk/reward proposition for long-term investors. We see significant upside for investors as HSBC continues to implement its "Five Filters" strategy, increases its focus on a key source of if its moat--unrivaled international corporate-banking interconnectivity--and sheds inefficient businesses. While we think that turmoil may re-emerge in Europe, we see HSBC as a haven from the storm because of its hefty capital base, deposit funding, and exceptionally low exposure to peripheral sovereign Europe.