HSBC's Earnings Mystery

By Stephen D. Simpson, CFA | August 04, 2010 AAA

Global banking giant HSBC (NYSE:HBC) is not going to win any points this time around for presenting clean and intelligible earnings. I am not suggesting that the company is hiding anything or attempting to mislead investors, but investors are certainly to be forgiven if they came away from Monday's report not really sure exactly how the company is doing.

At the most basic level, things are getting better for HSBC, but the pace of the "real" recovery (as opposed to the accounting recovery) is still rather slow.

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The First Half That Was
HSBC reported first half results that were certainly good enough to get cheers from the financial press and institutional investors. On first blush, that makes a certain amount of sense. The bank reported that loan losses were down about 40%, helped by a sizable drop in provisions in the North American business. Impaired loans continued to decline as a percentage of the total, and the company managed to leave the first half of the year with a return on equity of over 10%. (To learn more, check out Return On Equity from Investopedia Video.)

Well ... not exactly.

The bank *did* see a good rebound in the Asian side of the business (which is roughly half of the total), and overall loan balances did grow by 4% on a currency-adjusted basis. When you strip out a lot of the noise, though, it looks as though underlying revenue was actually down by at least 10%, costs were up around 5%, and much of the company's "profit growth" was achieved through the loan loss reserves that we have seen from other large banks like Citigroup (NYSE:C) and Bank of America (NYSE:BAC). Now, to be clear, this is not so much an issue of accounting integrity as it is "real earnings"; I argue that earnings growth achieved due to exceptional loan loss reserve releases amidst an uncertain economic environment is not high-quality growth.

The Road Ahead
That being said, it is not hard for me to see HSBC finding a path back to respectable performance relatively quickly. Asia does not seem to be scarred by the banking problems that are afflicting Europe and the United States, although I am concerned about whether China will successfully deflate its own property bubble (Hong Kong alone is about 20% of HSBC's business). In addition, there are plenty of stories bubbling up now about bad municipal loans sitting at Chinese banks.

Still, we are talking about the world's third-largest bank, with offices in more than 80 countries and operations in every permanently inhabited continent. So, unless you think that HSBC is hiding grievously bad loans on its books and/or that the global economy overall is doomed, HSBC will likely, at a minimum, recover in time with an overall global recovery. Here too is where it is important to remember that while the problems in the U.S. and Europe slowed things down in places like Brazil, India and China, underlying growth in those large countries is still quite strong.

Likewise, I expect that investors in European banks like Barclays (NYSE:BCS), RBS (NYSE:RBS) and Deutsche Bank (NYSE:DB) will probably feel better after seeing these results, especially with the reported rebound in HSBC's U.K. operations.

The Bottom Line
What I think HSBC investors or watchers should take away from this is that HSBC is doing better, but things are not as good as they look at first blush. Loan activity is recovering, led by Asia, and the company is seeing modest improvements in credit quality. Moreover, the company is in a strong capital position and looks poised to be a stronger hand coming out of this global banking mess.

All of that being said, the stock has had a nice little recovery since the panic around Greece abated. Right now, though, the stock is not quite cheap enough. It is is undervalued, but there are so many banks out there that are even more undervalued that I cannot get all that excited about this one, particularly if investors start getting irritable about earnings quality in the back half of this year. HSBC does have some scarcity value, as there are relatively few easily accessible Asian bank stocks for American investors, but scarcity alone does not make me want to own this today.

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